In this article, we review the U.S. income tax rules for Bitcoin transactions. Full details as well as a TLDR version are below!
Disclaimer: This series contains general discussion of U.S. taxes. As always, you should consult your own tax advisor in your jurisdiction to determine your specific situation as this is not personal advice; and consider any future guidance by the Congress/IRS after the date of this article. Under Circular 230 to the extent it applies, this article cannot be used or relied on to avoid any tax or penalties in the U.S., its States or any other jurisdictions.
Remember: In tax, there is always an exception, and an exception to the first exception.
Key Terms: “Convertible Virtual Currency” = CVC = Bitcoin (and some Altcoins); References to “Q&A” in this article are referring to the Notice 2014-21.
Part I-A: “Investment” In Bitcoin – buying and selling implications.
The U.S. Federal income tax consequences of Bitcoin transactions are very straight-forward, but guidance is too vague and has not been updated properly in a few years. The issue of crypto taxation has been on the Internal Revenue Service’s (IRS) radar for a long time, and in 2014, the IRS issued Notice 2014-21 to address cryptocurrency transactions. The IRS guidance alone does not explain every angle to the complex nature of Bitcoin (hard fork anyone?), leaving much uncertainty for U.S. citizens. Still the IRS will wield its authority to charge a 20% penalty (just one of many other penalties/interest provisions) in addition to back taxes to individuals who are not following Notice 2014-21 and reporting gains (See Q&A 16).
How does the IRS treat cryptocurrency?
According to the Notice, for U.S. federal income tax purposes, a convertible virtual currency (“CVC”) is treated as property (Q&A 1).
We all own property, a very simple concept, so what is “convertible virtual currency”?
A “convertible” virtual currency is a virtual currency that can be:
(1) Digitally traded between users and
(2) Purchased (and sold/exchanged) for U.S. Dollars (or other currencies including virtual currency).
Bitcoin is expressly listed in the Notice as an example of convertible virtual currency to be treated as property for tax purposes. So Bitcoin is what we call a “bright line” in the tax world, meaning obvious application of a set of rules. Similarly, we can guess the many Altcoins that are available on internet exchanges to trade for USD/Bitcoin would likely be a CVC by default.
Ok, Bitcoin is “Property”, So What?
The IRS code requires each U.S. citizen to report a gain or loss on the personal income tax return when investment property is later sold for U.S. dollars, or exchanged for other property (except for the “like-kind” exception). The tax treatment of the gain/loss depends on the U.S. person’s intention holding the property or how it relates to the taxpayer. For example, for a U.S. person buying and selling an investment, the tax may be charged at preferential tax rates for capital assets (see below); but if someone holds property merely as inventory to re-sell it at a markup, the property would not be a capital asset. Because Bitcoin or another CVC is “property,” the general buy/sell rules that apply to property will also apply to Bitcoin, including determining if the property is a “capital asset” (Q&A 6/7).
A U.S. person is responsible to keep track of their cost of acquiring each virtual currency at each point in time they make a purchase. They should track the cost in U.S. dollars (USD) when the currency is purchased.
When property is sold, the net amount received in USD (or value of other property received in USD) is used to determine the gain and loss (Q&A 2). The “gain” (or loss) on a sale of Bitcoin is subject to inclusion in the tax return, and may result in a tax (or potentially a benefit for a non-personal capital loss).
How is a gain or loss calculated?
A gain on the sale of Bitcoin (or another CVC) for U.S. dollars is calculated as:
1. Sales Price (U.S. Dollars received in sale net of fees)*
Minus
2. “Cost” Basis of Bitcoin**
= Gain (loss if negative)
Note * If Bitcoin is exchanged for other property instead of cash (including virtual currency), the USD value of new property received is the “sales price” above (unless a like-kind exchange exception is met).
Note ** The basis of property is usually its cost in a direct purchase, therefore, the US dollar spent to acquire Bitcoin (including direct transaction fees) is usually the “basis”. However, different rules apply if the Bitcoin is received through mining efforts, self-employment, a gift, etc. which will be discussed in another article.
Ok I have a gain, what do I owe the IRS?
It depends! In the U.S., personal income tax rates vary significantly based on each person’s specific situation (married, # of jobs, kids, income, investments etc.). The tax rate could be as low as 10% to as high as 39.6% in a tiered structure as you earn more dollars between January 1 and December 31. The highest rate a person will fall in is a “marginal rate” which represents the tax rate of their “last” dollar of income. These 10%-39.6% rates are the “ordinary” tax rates which would apply to typical income from your day job.
However, sales of capital assets owned more than a year are subject to more favorable rates known as “capital gains” rates
· 0% if you are in the 10-15% brackets
· 15% if you are in the 25-35% brackets
· 20% if you are in the 39.6% bracket – i.e. the 1%
· 28% if the CVC is treated as a collectible (see below*)
Also, consider that a gain from selling Bitcoin is combined with all the other income/losses that are reportable on the tax return, so if you want to know how your taxes look at the end, you still need all the other information you would normally collect. Seek an advisor.
*If any convertible virtual currencies become classified as collectibles by the IRS, there are less favorable tax rates that would apply (28%), but the IRS has not issued guidance to clarify if any CVC’s are collectibles.
Is every gain on Bitcoin capital gain?
As the Notice discusses, the tax treatment that applies to a gain on the sale/exchange of CVC depends on whether the individual’s holding is a “capital asset.” Generally, for individuals holding Bitcoin as an investment, the currency should be treated as a capital asset. You and your tax advisor will have to make this determination. If you are a day trader who made a mark-to-market election, I recommend to proceed with caution, seek specific tax advice from your advisor.
How do I track multiple purchases?
You will have to track each exchange account, wallet, etc. that holds your Bitcoin for you to have a full and accurate account.
If you have an account with Coinbase, you can generate a basis report that will track your activity and attempt to assign basis. However, while this may be ok for simple transactions, the site might not have the origin of basis of crypto that was transferred from another wallet into Coinbase, or fees you incurred outside of Coinbase. I have a Coinbase account but I have not yet tested the template for accuracy.
https://support.coinbase.com/customer/portal/articles/1496488-how-do-i-report-taxes-
Coinbase mentions presenting basis information on a First-In-First-Out (FIFO) basis; this is a U.S. tax simplification that is allowed for property treated as “securities,” and initially there was no indication that Bitcoin is a security for IRS purposes. Still, specifically tracking which units of BTC you buy/sell may be very difficult (which I presume is why the FIFO rule was created for stocks in the first place).
Below is a website that can help with the Cryptocurrency portion of the tax return. This is not a referral, I have no affiliation with this site nor have I tested its functionality/accuracy.
Can we just swap Bitcoin for another Crypto instead of selling it, to avoid gains?
This is generally a taxable event in the context of holding Crypto for investment (although some exceptions apply).
There is an exception called “like kind exchange”. When this exception applies, similar property can be exchanged without an immediate tax consequence. There is no clear guidance for CVC yet, but this will be discussed in more detail in another article soon.
Is it better if Crypto was treated by IRS as a “Currency” or a “Security”?
To be covered in another article soon.
Will you give any examples of gains/tax consequences?
Examples of the above rules will follow in a few days.
Takeaway (TLDR)
Because the IRS treats Bitcoin as property, a U.S. citizen should track when they buy/sell Bitcoin (and Alt coins). Similar to stock market gains, the Bitcoin gains/losses should be reported to the IRS (even if traded directly for another crypto currency). The seller may be able to apply the lower “capital gain” tax rate on the sale of Bitcoin if they own it for more than a year, which can be a very low rate in the U.S. compared to a normal “ordinary” wage tax rate. A tax advisor can hopefully help you figure out the tax consequence to your specific situation, but they need to know (a) that Bitcoin transactions exist in the first place and (b) whether the Bitcoins are capital assets - and of course (c) records of purchases and sales.
Photo Credits:
https://pixabay.com/en/users/stevepb-282134/
https://pixabay.com/en/users/geralt-9301/
Article Tracker:
· Introduction To Series:
· Part I-A – General Tax Consequences of Holding Crypto for Investment under U.S. tax law (part 1 examination of Notice 2014-21)
Section #1 (this article)
Appendixes - Coming Soon
Coming Soon:
· Part I-B – General Tax Consequences of Performing Services for Crypto in Exchange under U.S. tax law (part 2 examination of Notice 2014-21 and Sec. 83)
· Part II – Tax Consequence if you held and received Bitcoin cash during hard fork