What is Bitcoin, exactly? For the uninformed, it’s a form of virtual currency that uses a cryptographic encryption technology that focuses on secure storage and transfer. Unlike any conventional currency, it has no physical form: it’s not printed by a bank or a government. And it isn’t backed by these institutions either.
Bitcoins are created by “mining”- the act of using a powerful network of computers that are programmed to follow a specific mathematical formula that produces new cryptocurrencies. Mining is a very taxing process, and it takes the most advanced hardware to be able to produce them efficiently. You can mine bitcoins yourself or purchase them with cash, a credit card, or other virtual currencies. They are much like any currency that can be used to exchange with services or goods.
This relatively new form of currency, has been officially listed on many exchanges and paired with the world’s leading currencies like the euro or the US dollar. The United States Federal Reserve has also acknowledged bitcoin because of its growing importance to different industries and sectors. They’ve done so by announcing that any bitcoin-based investments or transactions cannot be illegal.
Initially, many people were attracted to it because of the fact that it was unregulated, and every transaction done using it won’t have any tax obligations. Virtual nature and “borderless” nature makes it difficult to keep track of, especially with international transactions. Additionally, governments all over the world have realized the attraction to black market dealers to make illegal transactions more elusive. It’s only natural that it’s one of the government’s main interests to have bitcoin within their radar. And this includes cryptocurrency taxes.
Is it taxable? The IRS explains that virtual currencies are digital representations of worth, and can act as mediums of exchange and storage. As of the moment, it doesn’t have any legal tender status within any jurisdictions. Digital currencies have equivalent values to physical currencies, so they can be used as substitutes for them.
The IRS makes it clear that reporting transactions is mandatory, regardless of the amount transacted with. Every American taxpayer needs to have a record that includes all relevant information related to selling, buying, investing, and using cryptocurrencies for exchanging services and goods.
It’s because of these very reasons (bitcoin is treated as an asset) that using bitcoin during most transactions will have a resulting capital gains tax. These transactions are:
For the first and third transactions, these entail you to mine yourself with your own resources, and either sell them in exchange for cash or use them to buy services or goods. The value you’ve incurred from these transactions is taxed from either a business or personal income perspective.
This is done after deducting the expenses required to mine said bitcoins. These expenses include electricity costs, the cost of computer hardware, and the cost of manpower needed to maintain them. So let’s say that you mined 100 bitcoins and sold them at $500 each. The $50,000 you’ve acquired needs to be reported as part of your taxable income, right before deductible expenses.
Bitcoins used for the second and fourth scenarios are considered more of an investment rather than an asset. So, for example, you bought them for $500 each, and you gave one up to exchange $300 worth of goods for. You, as an investor, gained some value over the bitcoins in a given holding period, and this attracts a capital gains tax on the value that you earned for exchanging or selling the bitcoins. If you’ve held it for over a year, it’s considered long-term. Otherwise, it’s short-term, but what are the implications of these time-brackets? Is there a difference?
If you’re holding it before a whole year is up, a capital gains tax under the short-term bracket is applied. This equates to your regular income tax. However, if you’ve held your bitcoins for over a year, a capital gains tax under the long-term bracket is applied. In America, the tax rates for people under 10% to 15% of the “ordinary” bracket enjoy a 0% tax. Those under the 25% to 35% bracket get 15%, while anyone above the 39.6% bracket gets 20%.
To sum it all up, you’re paying far fewer taxes for the long-term compared to the short term. However, any tax deductions are limited to any capital losses incurred. The limit of capital losses is equal to the total gains you’ve made in the same year added with a maximum of $3000 ordinary income.
As mentioned previously, the IRS released a notice that it is not a currency, but a property. This might seem like an inconsequential distinction at first, but it’s this very basis that the IRS makes the decision of how much tax an individual owes.
Bitcoin and taxes need regular reporting, and it’s not as simple as your regular tax reports. For one, it’s hard to determine the fair value when using it for sale transactions or purchasing. Nature of bitcoin is very volatile, and each day will often experience large fluctuations in price. The IRS notes that consistent reporting is encouraged. So if you’re using a high-price day for purchasing, you need to use that for sales too. Also, if you’re a frequent investor or trader, you can use the first in and first out rule or the last in and first out rule accounting techniques in order to lessen the tax obligations.
What will happen if someone scams you of your bitcoin, or maybe your cold wallet got stolen? In the past, you had the option of deducting this event as part of theft loss when paying taxes. However, this has changed with the new tax rules.
Here’s one other rule that isn’t too favorable for cryptocurrency users. The IRS will allow crypto owners to exchange all types of property to trade with a similar property and avoid any tax liability – so “like-for-like” exchanges are exempted.
Before the changes in tax law, owners, of course, needed to know if this type of exchange also applied to cryptocurrencies, where an owner trading in bitcoin for, say bitcoin cash is tax-exempted. Sadly, the current tax reform is limiting these kinds of exchanges to trades with real property only, and not privately-owned goods.
The first thing you need to do is to create an efficient system of record-keeping that includes all of your transactions. This way, keeping track of all your acquisitions and trades is easier. Identify your preferred method of cost basis as well as the exchange rate. Afterward, you need to record the bitcoin dispositions on Form 8949 and Schedule D. By keeping a detailed list of your crypto transactions: your income is accurately measured. Be sure to maintain your record because any lapse or incompleteness could essentially nullify all of your hard work.
Any user needs to find a reputable provider of the wallets. These providers create tools to provide extra security and mitigate some of the risks when trading, selling and buying while making the process user-friendly. Consider this as a form of investment to avoid a potential future hassle. You might also want to consider getting a cold-wallet instead, a bitcoin wallet in physical form that’s undeniably safer because it’s not exposed to the vulnerability of internet-capable devices.
For capital gains, regular strategies apply, where you offset your gains with your losses, you time dispositions in order to fall under the long-term bracket, harvest any losses, harvest all gains. If you’re having trouble with your strategies, consult with a financial advisor. Regularly check the tax rate. Any gains made are typically subject to 3.8% of the income tax net investment. If you want to try your hand at market trading, this means that any gains made during the short term are subject to be reported to Form 4797. All bitcoin expenses fall under the Schedule C deductible.
Bitcoin tax reporting is a bit of a hassle, but you won’t have to deduct any capital losses, at least (not unlike losses on bonds and stocks). Any of these losses can easily offset the rest of the capital gains you’ve made on sales. After you’re finished tallying all the losers and winners in your pot, you can’t really write off losses of over $3000. Always report your losses in your tax return to have a chance at reducing tax liabilities.