Bitcoin and the irs

Are There Taxes on Bitcoins?

More than a decade after Bitcoin’s introduction, there is still considerable confusion about its taxes. The cryptocurrency was conceived of as a medium for daily transactions but it is yet to gain traction as a currency. Meanwhile, it has become popular with speculators and traders interested in making a quick buck off its volatility.

The Internal Revenue Service addressed cryptocurrency transactions in its notice 2014-21. The agency stated that cryptocurrencies would be treated as an asset similar to property. In 2019, the IRS began including a question on its Form 1040 to determine whether the tax payer had any cryptocurrency transactions during the given tax year.

Depending on the type of transaction, assets are subject to various kinds of taxes. But the unique characteristics and use cases for Bitcoin means that there are several exceptions.

Key Takeaways

• Bitcoin has been classified as an asset similar to property by the IRS and is taxed as such.
• U.S. taxpayers must report Bitcoin transactions for tax purposes.
• Retail transactions using Bitcoin, such as purchase or sale of goods, incur capital gains tax.
• Bitcoin mining businesses are subject to capital gains tax and can make business deductions for their equipment.
• Bitcoin hard forks and airdrops are taxed at ordinary income tax rates.
• Gifting, donating, or inheriting Bitcoins are subject to the same limits as cash or property transactions.

Bitcoins & Taxation Frequently Asked Questions

Bitcoin is now listed on exchanges and has been paired with leading world currencies, such as the U.S. dollar and the euro. The U.S. Treasury acknowledged the growing importance of bitcoin when it announced that bitcoin-related transactions and investments cannot be deemed illegal.

Here are some answers to important questions about taxes associated with Bitcoin.

Do you have to pay taxes on Bitcoin transactions?

The short answer to that question is yes. Bitcoin’s classification as an asset makes its tax implications clear. The IRS has made it mandatory for taxpayers to report bitcoin transactions of all kinds, no matter how small in value. Every U.S. taxpayer is required to keep a record of all buying, selling, investing or usage associated with their Bitcoin. The IRS sent warning letters in July 2019 to more than 10,000 taxpayers it suspected “potentially failed to report income and pay the resulting tax from virtual currency transactions or did not report their transactions properly.” It warned that incorrect reporting of income could result in penalties, interest, or even criminal prosecution. .

What types of Bitcoin transactions are taxed?

The following types of transactions using Bitcoin are considered taxable:

• Sale of Bitcoins, mined personally, to a third party.

For example, if you mine a Bitcoin and sell it to another party for a profit, then you have to pay capital gains taxes on the transaction.

• Sale of Bitcoins, bought from someone, to a third party.

For example, if you purchase Bitcoin at a cryptocurrency exchange or from another person and sell it for a profit, then you have to pay capital gains taxes on the transaction.

• Using mined Bitcoins to buy goods or services.

For example, if you purchase coffee using Bitcoin that you mined at home, then you have to pay taxes on the transaction. (The amount of taxes depends on the specifics of the transaction, such as the value of Bitcoin at the time of sale and the price of coffee).

• Using Bitcoin, bought from someone, to buy goods and services

For example, if you withdraw Bitcoin from an exchange to your personal wallet and make a goods purchase with it, then you are liable for capital gains taxes.

The first and third scenarios are taxed as personal or business income after deduction of expenses incurred during the process of mining. The second and fourth scenarios are more like investments in an asset.

Let’s say you purchased a Bitcoin for $200 and sold it for $300 or used an equivalent value in goods. You are liable to pay capital gains tax on the $100 profit from the transaction.

Do I have to pay taxes if I receive cryptocurrencies as payment for goods and services?

Salaries or payments received in cryptocurrencies are treated as ordinary income for tax purposes. The value or cost basis for the cryptocurrency is its price on the day at which it was used for salary payment.

Do I have to pay taxes if I am a Bitcoin miner?

Yes. Cryptocurrency mining is considered a taxable event. The fair market value or cost basis of the coin is its price at the time at which you mined it. The good news is that you can make business deductions for equipment and resources used in mining. The nature of those deductions differs based on whether you mined the cryptocurrencies for personal or individual gain. If you run a mining business, then you can make the deductions to cut down your tax bill. But you cannot make these deductions if you mined the cryptocurrencies for personal benefit.

Do I have to pay taxes when I convert from one cryptocurrency to another?

Conversion of one cryptocurrency to another, say from Bitcoin to Ether, is classified as a like-kind transfer under the Internal Revenue Code 1031. The IRS allows you to defer income tax on such transactions. Many crypto investors took advantage of this provision to defer their income from crypto trades during the early days of crypto trading. However, the Tax Cuts and Jobs Act (TCJA) of 2017 put an end to that practice by clarifying that like-kind transfers are restricted to property transactions.

What are the tax implications when a blockchain undergoes a hard fork or cryptocurrencies are dropped?

Hard forks of a cryptocurrency occur when a blockchain split occurs, meaning there is a change in protocols. A new coin, with differences in mining and use cases from its predecessor, is created. Holders of the original cryptocurrency may be given new coins. This practice is also known as an airdrop and is also used as a marketing tactic by developers of new coins to induce demand and usage.

Previously, there were several questions swirling around the tax implications of hard forks and airdrops. For example, should they be treated as stock splits or dividends? Is an airdrop free income?

In a 2019 ruling, the IRS clarified that hard forks do not result in gross income, if the wallet holder does not receive units of cryptocurrency. Airdrops, on the other hand, qualify as gross income after the holder receives units of a new cryptocurrency either after a hard fork or by marketers of a coin. In the latter case, the quantity and time at which a crypto wallet holder receives the new coins determines the tax amount. Airdrops are taxed as ordinary income.

What are the tax implications of donating, gifting, or inheriting cryptocurrencies?

Cryptocurrency donations are treated in a similar fashion as cash donations. They are tax-deductible. An appraiser will assign a fair market value for the coin based on its market price at that time. The donor is not required to pay any taxes on the price gain. Gifts of cryptocurrency below $15,000 are not subject to income. If the recipient of a crypto gift over $15,000 decides to sell the gift, then their cost basis remains the same as that of the donor. Inherited crypto assets are treated the same way as other assets, meaning they are subject to the same estate regulations as other assets.

What are some special considerations for cryptocurrency taxes?

Taxation of Bitcoin and its reporting is not as simple as it seems. For starters, the volatility of bitcoin price makes it difficult to determine fair value of the cryptocurrency on purchase and sale transactions. It is also difficult to use identify the appropriate accounting method for use in cryptocurrency taxation. Last In, First Out (LIFO) and Highest In, First Out (HIFO) have the potential to decrease taxes but the IRS has approved very few instances of their use for crypto traders. First In, First Out is the most commonly-used method for cryptocurrency accounting.

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Targeted by IRS? What Cryptocurrency Owners Should Know

The U.S. Internal Revenue Service (IRS) has started sending out new letters to cryptocurrency owners suspected of owing crypto-related taxes. A tax expert has shared with news.Bitcoin.com what crypto owners should know, including how to handle tax letters from the IRS and avoid an audit.

How to Deal With IRS Letters

The IRS has ramped up its efforts to ensure that cryptocurrency owners pay all crypto-related taxes. It has begun sending out a new round of tax letters similar to the ones sent to about 10,000 crypto owners last year. There are three types of letters, referred to as Letters 6173, 6174, and 6174-A. In addition, the IRS recently moved the cryptocurrency question from Schedule 1 to the top of Form 1040, the main form used by about 150 million people to file their taxes.

Clinton Donnelly, the founder of Donnelly Tax Law, has helped over 12,000 crypto owners with their tax returns, avoiding over $40 million in gains by using like-kind exchange calculations. He has shared some insights with news.Bitcoin.com to help crypto owners deal with the IRS, its crypto question, and tax letters.

BC (Bitcoin.com): What are the differences between the three IRS letters, and how should cryptocurrency owners react to each of them?

CD (Clinton Donnelly): Letters 6174 and 6174A are similar. They advise the taxpayer to double-check that they reported all their income. Letter 6174A goes into a little bit more detail.

Letter 6173 differs by requesting that the taxpayer submit a signed statement if they don’t amend their returns. This statement reads: “I declare under penalties of perjury that I have examined this entire document, including all attachments and accompanying statements, and that the enclosed is true, correct, and complete.” Perjury is the intentional act of swearing a false oath. The sentence is one year in prison and or fines. The wording of this oath is the same as on the Form 1040 when you sign.

Additionally, Letter 6173 is the letter sent to taxpayers suspected of engaging in criminal tax evasion. If you get this letter, you should be concerned.

Receiving this letter means that the IRS has evidence suggesting criminal wrong-doing. Ultimately, it would be best if you contracted with a tax attorney experienced in criminal tax cases. This attorney should employ a top-notch crypto tax audit specialist to do the crypto aspects under the protection of a Koval letter that extends attorney-client privilege to the tax audit team’s work.

BC: What should cryptocurrency owners do if they receive a tax letter from the IRS?

CD: You should contact a tax professional specializing in crypto audits. It would be best if you talked to someone who understands the audit process and how the IRS is treating crypto income in audits. He/she would be the best person from whom to gain your knowledge.

If you receive a letter, it is crucial to understand that you are now on the IRS’ audit radar. That means your odds of being audited are significant.

Remember, an auditor’s job is to find mistakes in your return. It can be expensive to defend yourself against the IRS because audits often take a year and a half to resolve. This stress can take a heavy toll on letter recipients.

Anyone not experienced in crypto audits will make a poor advisor if you’ve received a letter. It’s essential to ask your advisor if they have experience in crypto audits.

BC: Can you elaborate on the crypto holding threshold of taxpayers who got an IRS letter last year versus this year?

CD: I had a couple of dozen clients who got the 2019 letters. These recipients had in common that they all had a crypto portfolio valued at over $900,000 or more in 2017.

It is a mystery how the IRS determined these recipients. Some of them never used U.S. exchanges, yet the IRS was aware that they were whales.

The recipients of the 2020 letters have maximum portfolio balances in 2017 of only $100,000 or more. They also appear to be recipients of Coinbase 1099 forms.

BC: Are taxpayers with only small crypto holdings likely to receive one of these letters from the IRS? Is there a level of crypto holdings the IRS deems “too small” to send letters about?

CD: Every time the IRS mails out a letter, it generates work for them when the taxpayer responds. They do not have the workforce to send out millions of letters. Also, there are diminishing returns as they pursue smaller taxpayers.

BC: How does the IRS find out about taxpayers’ crypto holdings?

CD: The IRS doesn’t disclose their methods, but we gather clues from what IRS executives say and past methods. They have said that they are using data mining techniques to identify those to examine. An obvious clue is receiving a 1099 tax form from U.S. crypto exchanges. They then correlate those against taxpayers who have words like bitcoin, cryptocurrency, or BTC on their return.

The methodologies used in IRS criminal investigation are different than the non-criminal selection process. In a criminal investigation, they use Chainalysis applications, etc., to follow the path of ownership. This methodology is not used in non-criminal cases.

The U.S. has partnered with Australia, UK, Canada, and the Netherlands to collaborate on cryptocurrency criminal activity and money laundering enforcement. This group, known as the J5, share intelligence, and coordinate enforcement.

BC: Do you expect the IRS to send out letters to more than 10,000 crypto owners this year?

The number of letters sent out will match the amount of workload they want to take on.

BC: What kind of audit is the IRS likely to conduct on crypto owners?

CD: I have two clients in full IRS audit of their cryptocurrency reporting, so this is still an evolving story.

The IRS auditors, called Revenue Agents, are specialists in investigative accounting. Different specialists support them. There are crypto-trained specialists that the auditor relies on to understand the crypto results. They can also contract crypto gain calculator companies to do their gains calculations and participate in interviews.

It is clear to me that these initial audits will be a learning experience for the IRS. Crypto reporting is so complicated that they will be studying the best ways to do a crypto audit.

BC: What fees and penalties are taxpayers who do not report their crypto income likely to incur?

CD: The purpose of the audit is to determine the correct amount of tax owed by a taxpayer. If a taxpayer is determined to owe more taxes than were paid, this amount is called the understatement. Since this amount should have been paid originally, a failure-to-pay penalty is added. This amount is 0.5% of the understatement per month for the first 36 months from when it was originally due. Interest is charged on the understatement from the original due date. The interest rate is changed quarterly. Presently, the annual interest rate is 5%.

Finally, the accuracy-related penalty is added under tax code section 6662. This penalty is 20% of the understatement if the additional tax more than the greater of 10% of the tax required to be shown on the return for the taxable year or $5000. In certain situations, the penalty can be increased to 40%.

If the auditor determines that the taxpayer had been intentionally deceptive on the return, the accuracy penalty is replaced by a 75% fraudulent return penalty.

BC: What do you think of the crypto question the IRS asks on Form 1040?

CD: The question intends to educate the taxpayer on the need to report crypto income. The term “virtual currency” is not defined in the tax law or regulations. It only appears on an IRS Notice 2014-21, which is not binding. Further, the definition of virtual currency is very broad, including frequent flyer miles and shopper loyalty point cards. So, by the IRS definition, almost every taxpayer should say Yes.

They could have just made a statement on the front page of Form 1040. Instead, they expressed it as a yes or no question. That converts the answer into a legal statement signed with an oath of perjury.

To me, this question seems to violate the first amendment protections on free speech by making the act of owning virtual currency a stigma. The fifth amendment protection against self-incrimination entitles a citizen not to answer such a question without due process.

BC: What is the significance of the IRS moving the crypto question from Schedule 1 to the top of Form 1040?

CD: A common complaint is that taxpayers were unaware of the need to report cryptocurrency income. All taxpayers will be without excuse in 2020. In 2019, the virtual currency question was on Schedule 1, which is not a Schedule that is always required.

BC: Will taxpayers who answer “yes” to the crypto question on Form 1040 (or Schedule1) still receive a tax letter from the IRS?

CD: Most taxpayers are terrified of this question. The existence of the question has caused many people to be more diligent in reporting their crypto income. But I strongly doubt all who check “Yes” will receive a letter.

BC: If taxpayers used to trade crypto but not in the past couple of years, does answering “no” to the crypto question on Form 1040 raise a red flag to the IRS and increase their chance of an audit?

CD: Good question. The IRS is using data mining techniques for determining who to examine. The method outlined in the question could be part of that analysis.

The U.S. federal tax system is voluntary. (It is much more voluntary than other developed countries.) The IRS depends heavily on collective fear to encourage compliance. The fear of being audited is massive.

In my experience, smaller investors have a greater fear of being out-of-compliance than larger investors.

No question placing the virtual currency question on the top half of the first page of the return is designed to increase crypto-owners’ fears drastically.

Are you worried about receiving a letter from the IRS? Let us know in the comments section below.

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