Do you pay taxes on bitcoin

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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How Bitcoin Is Taxed

The IRS says Bitcoin is property and can be subject to capital gains tax

In 2014, the IRS has ruled that Bitcoin and other «convertible virtual currencies» must be treated as property, not as currency. There are, therefore, tax consequences whenever Bitcoin is bought, sold, or traded.

This might sound like a minor distinction, but it’s not. It determines how Bitcoins are taxed, the information you’ll need to make sure your taxes are calculated correctly, and what tax-planning techniques you can use to try to minimize your taxes on Bitcoin transactions.

The IRS and Virtual Currency

The IRS has indicated that virtual currency doesn’t have status as legal tender in any jurisdiction. It’s referred to as «convertible» virtual currency if it has an equivalent value in real currency, or if it ever serves in place of real currency. It can be exchanged into another currency, either real or virtual, and it can be digitally traded.

When Do You Have to Pay Taxes on Bitcoin?

The IRS further indicates that Bitcoin is treated as property and is subject to general tax principles. You must include in the fair market value of the currency in U.S. dollars in your gross income if you’re paid in Bitcoins for goods or services. Transactions using virtual currency should be reported in U.S. dollars.

The fair market value of Bitcoins can be established by converting them into U.S. dollars at the current exchange rate at the time they’re received.

You’ll also have a capital gain or a capital loss if you dispose of Bitcoin, because it’s considered property for tax purposes. A gain represents income, and income is taxable even if you’re paid in virtual currency.

«Every Bitcoin transaction is taxable,» writes Tyson Cross, a tax attorney who specializes in virtual currencies. «Bitcoin users will have to calculate their gain or loss every time they purchase goods or services with Bitcoin.»

As with other types of property, you would acquire it first, often by exchanging cash for the asset. You then own the property for a period of time, and you might eventually sell it, give it away, trade it, or otherwise dispose of it. Capital gains taxes come due at this point.

Four things will happen when property is disposed of:

• Income is realized from any gain.
• Gain is measured by the change in the dollar value between the cost basis or purchase price and the gross proceeds received from the disposition or the selling price.
• The tax rate that applies depends on whether the property was held for one year or less (a short-term gain) or for more than a year (a long-term gain).
• Disposition of property is reported on your tax return using Schedule D and Form 8949 or Form 4797. These forms require that you «show your math» when you’re calculating a gain or loss. You’ll do your calculations right on the form, per instructions.

Reporting Cryptocurrency Activity

Virtual currency transactions must be reported on page 1 of your individual tax return. Beginning in 2020, if you engage in any transaction involving virtual currency, you must check the appropriate box next to the question on virtual currency, even if you received any for free, including from an air-drop or hard fork. Do not check this box if you only engaged in transactions among wallets that you yourself own.

An Example of Capital Gains Tax

Suppose you purchased Bitcoin for $30,000. You then sell it for $50,000, so you have a $20,000 capital gain. This would be a short-term gain if you held the Bitcoin for a year or less, so it would be taxed as ordinary income according to your tax bracket. It’s a long-term gain taxed at a rate of either 0%, 15%, or 20%, depending on your overall income, if you owned the Bitcoin for longer than a year.

All of your gains would be short-term, and you would report them on Form 4797 if you elect market-to-market trading. Any Bitcoin-related expenses would be deductible on Schedule C.

The Net Investment Income Tax

You might also find that you’re subject to the 3.8% net investment income tax that applies to investment income. It comes due if you’re a single taxpayer, and your overall modified adjusted gross income (MAGI) from all sources is more than $200,000 for the year. The threshold increases to $250,000 for married taxpayers who file jointly and qualifying widow(er)s. It drops to just $125,000 for married taxpayers who file separate returns.

This additional 3.8% tax rate applies only to investment income, not wages or most self-employment income.

How to Pay Taxes on Bitcoin

Establish a record-keeping system for all your transactions, and keep track of when you acquire and when you dispose of Bitcoin. Identify your cost basis method and your exchange rate. Then record the dispositions of Bitcoin on Schedule D and Form 8949.

Keeping detailed records of transactions in virtual currency ensures that income is measured accurately.

Normal capital gains strategies apply: You can offset gains with losses, time your dispositions to qualify for long-term treatment, harvest your losses, and harvest your gains. A tax professional can help you with these concepts. The income is reportable on your personal tax return, normally due April 15 of each year unless you request a six-month extension from the IRS. (Because of pandemic-related complications, the deadline for filing 2020 personal tax returns is May 17, 2021.)

What Happens If You Don’t Pay Taxes?

Bitcoin is no different from other sources of taxable income if you shrug your shoulders at the IRS and don’t pay, even if you didn’t know you were supposed to do so.

First, the IRS will most likely know about your activities, or at least it can check and confirm them. All Bitcoin transactions are permanently stored in the Bitcoin network, which is public.

You’ll no doubt receive a notice from the IRS if you neglect to pay taxes on this income. You’ll be charged interest at the rate of 0.5% of the amount of tax you owe, up to a cap of 25% of the unpaid balance. You’ll also be penalized at the rate of 5% a month as of 2020.

The IRS additionally has numerous enforcement options for collection, from liens against your property to levies on your income and bank accounts.

Tax Tools for Bitcoin

Casual Bitcoin users might want to consider using a reputable Bitcoin wallet provider that has implemented risk-mitigation tools to make buying, trading, and selling Bitcoin more secure and user-friendly. Even aside from tax considerations, investors should take a look at wallet providers or registered investment vehicles with the kind of security features that one might expect from a banking institution.

These tools might come in handy both when you’re handling transactions and when you’re planning for taxes.

BitcoinTaxes, web-based software for importing data and calculating gains/losses, can be helpful as well.

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