You know what separates a good investor from a great investor?
Why do you think Warren Buffett is so successful? He rarely cashes out his investments. He strays away from capital gains. Sure, you can say that’s just a by-product of his investing strategy of holding forever, but it also shows you the power of knowing how to deal with taxes.
A savvy investor knows the ins and outs of taxes, or hires someone who does. Investing in a CPA is a worthwhile investment. But it’s hard to find a CPA who knows their way around virtual currency. So for this post, I am going to curate everything I can find on Bitcoin taxes and distill it here for you. This is going to be fun.
If you want to go straight to the source on virtual currency taxation, why not check the IRS? For the IRS, Bitcoin is “property” instead of currency. This means Bitcoin taxation happens with short-term or long-term capital gains. The tax rate will range from 15-20% depending on the fair market value price.
For Bitcoin to be known as “property” instead of “currency” is favorable because tax implications are more favorable for investors. Accrued gains and losses are a good thing for investors because the max rate that is liable for taxation is 15%. Compare that to the ordinary income rate of 25% and we got a winner. Simply put, long-term holders win because their tax rates are low. For investors who make money off of short-term capital gains (traders), there will not be as much benefit.
Short-terms traders who have huge losses will be at a huge disadvantage because losses that could be written off now will have to be carried forward for several years. Not only is this a matter of time working against a short-term investor, but benefits which could be taken advantage of are now passed on for later.
General Rules For Property That Also Apply To Virtual Currency
- Just as a payment made in property is reported, any payment with virtual currency also goes through reporting.
- Any payments made to independent contractors, or service providers are liable for taxation.
- Any virtual currency paid to employees is liable for taxation to the employee, and is withheld by federal income tax, and payroll tax.
- Gains or losses from an exchange or sale differ depending on whether the virtual currency is a capital asset in the hands of the taxpayer.
Basis means cost for acquiring Bitcoin. When it comes to Bitcoin taxation though, this is important as it gives you a benchmark to let you know whether you’re at a gain, or loss. What’s not commonly known is acquisition costs like commissions, or wire transfer fees are also included in the basis. But adding acquisition costs and the price you paid for your Bitcoin isn’t that simple when determining basis.
Situations like different prices and different times separates other Bitcoins from each other. When you’re Bitcoins differ from each other because of those factors, it will create a different basis and cause confusion. In this case, we use systems to determine basis. This makes it easier to choose a basis because choosing the highest price, or best coin for tax implications isn’t allowed.
The first system is called “First in, First out”. Or, FIFO. If you use this method, it is assumed that the first coin you purchase is the first coin that’s sold. Besides FIFO and cost basis, other methods such as LIFO and average cost method offer alternatives, but speak with an accountant before trying these alternatives.
Here are some tips and tricks for Bitcoin investors:
- Establish a record-keeping system
- Establish your cost basis
- Know your tax rates
- Deduct interest expense, investment expense, rent expense, depreciation expense on your Schedule A
- Deduct consulting fees for how to handle tax treatment of Bitcoin
- Keep separate wallets for short-term trading, long-term trading, and personal spending
Dealing with Bitcoin taxation is still new. There will no doubt be new updates to the tax code and record keeping will be essential to avoid any errors when it comes to Bitcoin taxation. This is why I’ve dedicated a section on record keeping.
If you don’t keep records and report extra gains, you face the possibilities of dealing with penalties when audited. In addition, not keeping records will dampen your chances of having favorable tax advantages. If you don’t keep your records, you might have to claim a zero basis and characterize your gains as short-term to avoid penalties. This makes sure you’ve paid the maximum amount of taxes while avoiding other penalties because you’ve paid the maximum amount on your gains.
Keeping records is necessary when purchasing virtual coins. You need to determine your gain/loss along with your holding period to prepare for tax returns. Luckily, most exchanges contain a spreadsheet which contains all the information you need to present to the IRS.
It is advisable to keep tax returns for up to 6 years because the IRS can go back and audit returns for up to 3 years. In addition, you have another 3 years if your tax return omitted more than 25% of your income which adds up to 6 years. If you committed civil fraud or never filed a return, then you might as well keep them FOREVER, because the IRS can just audit you anytime.
Software To Help You With Record Keeping
This software is a first of its kind. A tool that helps with tax preparation to calculate tax obligations for Bitcoin traders, Libra Tax makes tax returns easier and efficient.
One example of Libra Tax’s efficiency is helping Bitcoin users aggregate information in minutes by using the power of Blockchain. If you don’t use Libra Tax, the task of tracking the price you purchased and redeemed Bitcoin can take hours, or even days. Another problem Libra Tax solves is with virtual currency users who have multiple wallets.
If you have multiple wallets then you know how hard it is to keep track of everything. It makes it difficult to track progression and if you’re an investor, that is not healthy for business. But Libra Tax has figured out this problem by integrating with every major wallet and exchange provider. Now, Libra Tax users can track every wallet they own on one screen instead of going back and forth looking at the numbers.
Alongside being able to track your wallets simultaneously, Libra Tax now supports currencies all over the world. The list includes the Australian Dollar, British Pound, Canadian Dollar, and Chines Yuan just to name a few. All of these features make Libra Tax the go-to software for preparing tax returns. Even though the software is new, they’re constantly re-innovating themselves.
PayByCoin add-on (Quickbooks)
PayByCoin is a tool which help merchants receive payments in Bitcoin. It’s free to install and it doesn’t include transaction fees for both the merchant and customer.
It works like this. Imagine a customer wants to pay in Bitcoin. Assuming the merchant links their Quickbooks online account to the payment system then the Bitcoin payment will go there. Once the payment goes through, the coins will go into the merchant’s online account. Once the transaction completes, Intuit PayByCoin reconciles the transaction in Quickbooks online. It’s easy peasy lemon squeezy.
Fair Market Value
The IRS requires Bitcoin holders to record the fair market value of their currency on the date received. To determine fair market value, exchanges like BitStamp, or wallet services like Coinbase can be used to track fair market value. Another way you can get an accurate assessment is to sell some Bitcoins and look at how much it costs for a buyer. But be wary because Bitcoin is volatile, so a split second can make the difference between a sound valuation, or error.
The IRS defines fair market value as “a virtual currency listed on an exchange, and the exchange rate is established by market supply and demand, the fair market value of the virtual currency is determined by converting the virtual currency into U.S. dollars … at the exchange rate, in a reasonable manner that is consistently applied.” Even if your coins had a specific cost, remember, fair market value isn’t about history, it’s about supply and demand.
What is a convertible currency?
In the language of the IRS it’s “listed on an exchange and the exchange rate is established by market supply and demand”. Another term for convertible currencies is “an equivalent value in real currency, or which act as a substitute for real currency.”
Other currencies that can’t be converted to real currencies are also considered taxable by the IRS. If your virtual convertible currency can also be paid for goods and services, guess what?
It’s also liable for taxes.
What Happens When Bitcoin Is Sold Or Disposed Of From A Tax Perspective?
Since Bitcoin classifies as property, we apply property transactions to Bitcoin. If there’s any gain on the property, income is realized when sold. There really is nothing else to it. Another tax code that applies to Bitcoin is the way gains measure. The difference between the cost basis (purchase price) and money from selling (sales price) is the gain. In addition, tax rates vary depending on the amount of time the asset was held. If you’re new to virtual currency, remember the tax forms are Schedule D and Form 8949 for reporting taxes from Bitcoin or any other virtual currency.
But remember, not all coin holders hold for the long-term. Some trade for the short-term, but others such as miners generate their own coins. Read the next section to find out how Bitcoin taxation affects miners.
How Does Bitcoin Taxation Affect Miners?
Income from mining is taxable. Sometimes miners like to sell on a gain, and reporting gains are taxable. But if there’s a loss, the miner has to report that loss. On the date miners receive their coins, it classifies as income at market value. If you’re a miner and don’t hedge your losses, your throwing money out the window. The IRS allows you to offset income by up to $3,000 per year on losses. So take advantage of that rule whenever plausible.
If you trade Bitcoin, it’s important to remember how much the Bitcoin is worth at the time of trade because the IRS requires specific detail when filling out tax forms. As I’ve said earlier, Bitcoin reports on Schedule D, and it classifies as a capital asset. It can’t be a foreign currency because it’s not legal tender. In other countries, tax regulations are different just like any other rules.
In Australia, they recently ended a double taxation enforced on cryptocurrencies. If the law held up, Bitcoin taxation happens when purchasing Bitcoin, and then buying goods, or services with it. With tech advocates criticizing double taxation, legislation becoming more lenient, virtual currencies are getting a better shake. The new legislation will turn virtual currency from a property/good service classification to being classified as currency.
What Is My Tax Basis If I Mined My Bitcoins?
It depends if your mining activity is a “trade” or “business”. This is a big part in determining what your basis will look like. But in general, miners recognize their coins as income, and the market value for that day is their basis. With that market value, you can calculate your gains/losses.
What If I’m a “Day Trader?”
There is no definite answer for tax treatment with day traders. Generally, tax treatment for day traders is the same as investors. But if you’re trading activity rises, it’s possible your trading will classify as a “trade” or “business”, in which case income will be known as “ordinary income.” To be certain on where your position stands, be sure to consult with somebody in Bitcoin taxation.
What If I Exchange My Bitcoins For Altcoins (like-kind exchange)?
In real estate, when you switch a property for another property without incurring capital gains tax, you use the 1031 exchange. For virtual currencies, the same thing won’t happen. To give you context, like-kind means “having the same rights, characteristics, and obligations.” Exchanging one coin for another wouldn’t work because different coins have different characteristics. Whether it’s differences in smart contracts, or code, alternate coins can’t switch with one another without realizing gains.
How Do Taxes Apply To Donations?
Bitcoin users making donations doesn’t exempt investors from tax liabilities. And there are three situations where this happens:
- The first scenario is the most favorable position for investors. Imagine yourself donating Bitcoins to somebody else. But before you donate, you make sure your Bitcoins are older than a year, and you haven’t cashed out your coins. This is great for the investor because they can write-off the fair market value of their donation (up to 30% adjusted gross income) without incurring capital gains tax. All the recipient party has to do is report any donation above a $500 fair market value on form 8283, and file another return regarding federal income taxes for property gifts that pass the $500 threshold in a single year.
- The second scenario happens more often. If an investor wants to donate to charity, but the charity can’t accept Bitcoin, the investor must sell their coins to get cash for donation. This makes the investor liable for capital gains taxes, and tax rates for capital gains can range from 15-20%. On the other hand, the investor can still write off the donation against ordinary income.
- The third scenario depends on the 501(c) application status. The 501(c) allows organizations to exempt certain taxes, and if accepted by the IRS, a donation will be tax-exempt, even if it’s Bitcoin. If the application is denied, the organization will be liable for capital-gains tax. Another possible scenario is when an investor sends Bitcoins but the application is pending. At that point, the Bitcoins would be liable for capital-gains tax, but if the application passes, both the donor, and charity will be able to write off donations retroactively.
How Do Taxes Apply To Gifts?
When receiving a gift it’s important to differentiate between a “gift” or a “tip”. Even if a recipient receives Bitcoin as a gift, it doesn’t mean it’s exempt from taxation. It’s liable for Bitcoin taxation because when the recipient receives the gift, they’re still liable for capital gains and losses.
Generally, the cost basis of the gift is the price you got it at. However, there is an important exemption. If your friend’s basis is more than market value at the time, then wait to sell or exchange your coins until you find your basis. If this is the case then I recommend these rules to help you determine the basis:
- Calculate the gain/loss using your giver’s basis
- If there is a gain, then just stick with the default rule with gains
- If there is a loss, then don’t inherit the giver’s basis. Instead, use the market value at the time you received the Bitcoins to recalculate the gain/loss
- After recalculating, check if you still have a loss. If there’s a loss, then use the market value as your basis. If there’s a gain, then don’t report anything. To clarify, this means you literally don’t have to report anything if you have a gain.
Dealing with this tax treatment can get confusing. But here is a rule to help you understand the gift tax treatment
THE RULE IS YOU WON’T RECEIVE ANY LOSSES WHEN YOU RECEIVE BITCOINS AS A GIFT. IT DOESN’T MATTER WHO YOU GOT IT FROM.
Applying this rule, let’s set up a scenario to give it context.
Imagine the person giving you the gift has a basis of $500. And the market value for the coin is $250 at the time you get the gift. If the sales price at another date is $1000, you inherit the giver’s basis of $500 and report a gain of $500. If the sales price is $100, then you inherit the market value at the date you got the gift which was $250, and report a loss of $150.
Beginner tip here regarding taxes: When you receive Bitcoins as a gift, remember to ask the person what their basis was when they got their Bitcoin. And don’t forget to ask what date they acquired their Bitcoin. Finally, don’t forget to write down your market price and the date of your gift.
How Does The IRS Handle Missing Bitcoins?
The infrastructure around the cryptocurrency community is different amongst coins. There are different coding and incentives with each coin, not to mention regulation with each one. This is why virtual currencies are as volatile as they’re now.
With all this uncertainty, the theft and fraudulent activity surrounding Bitcoin doesn’t help either. Add the fact the IRS doesn’t support lost Bitcoins and this makes matters worse. But even though the tax code isn’t as helpful as it could be for investors, there are still some help if you have a loss.
Losses can only be claimed if the loss exceeds adjusted gross income by more than 10%. If you do discover a loss, you can only use it in the year discovered. And the minimum requirement for you to claim a loss is $100. All these rules come from section 165 of the tax code.
With the rise of Bitcoin from $100 to over $6,000 dollars in a few years, prepare for the IRS to enforce more laws regarding virtual currencies. In 2015, it was reported that only 802 people declared a capital gain or loss for Bitcoin. That won’t happen anymore because the IRS has found new methods to track down Bitcoin users.
One of the ways the IRS tracks people down is through Chainalysis. This software helps with anti-money laundering using investigative tools to “successfully track, apprehend, and convict money launderers and cybercriminals.” It basically identifies owners of digital wallets and lines up transactions with tax returns. Remember, if you don’t correctly report transactions, you could potentially pay for a penalty or fine. If you’re actions are severe enough, you could even face criminal action.
It’s imperative that you maintain your records. Making sure you know your transactions along with gains and losses. Using software like Libra Tax will help you with record-keeping and tax preparation. If you have multiple wallets, transactions can get confusing so I highly recommend using Libra Tax because it helps you aggregate vital information and displays all the information on one screen. This makes it easier and faster for you to prepare taxes.
With the cryptocurrency market at $160-$170 billion dollars, Bitcoin taxation will have huge implications. This will greatly impact the accounting and tax industries because the virtual currency market is becoming more and more mainstream. Revenue recognition, market valuation, and the characterization of profits and losses will get a makeover just because of Bitcoin. Just take this post for example. There are different rules for different scenarios such as gifts or donations, the tax code will definitely change.
Don’t wait to get ready for your taxes! There will be more updates coming, which means more implications. Separating yourself from other investors takes a great deal of knowledge on taxes which is also why you should consult a tax professional familiar with Bitcoin taxation. Take action now!