Wondering how the world of cryptocurrency and Bitcoin tax law works? That’s no surprise. A study in May 2017 estimated that at least 3 million people worldwide are active users of cryptocurrencies such as Bitcoin. The IRS is never far behind when money is on the move, so cryptocurrency and Bitcoin tax law 101 is a hot topic.
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Here are a few of the most common issues we see in practice, and what they mean for you as a taxpayer.
Reporting cryptocurrency accurately
Bitcoin and other cryptocurrency users must report income, both domestic and foreign, from all digital currencies. According to the Internal Revenue Service (IRS), it is mandatory to report all bitcoin transactions, of any value. Therefore, any US taxpayer who buys, sells, invests in, or pays for services or goods with Bitcoin or other cryptocurrencies must keep records.
The IRS’s position on what cryptocurrencies are is a little more confusing. The agency considers paying for goods and services with cryptocurrencies a kind of bartering, so Bitcoin and other cryptocurrencies are being treated as assets. This means using them even for simple transaction can cause you to incur a capital gains tax.
How long you held the cryptocurrencies before spending or otherwise using them determines whether you incur a long-term or short-term capital gains tax. If you held the Bitcoin for less than a year before exchanging them, you pay a short-term capital gains tax at your ordinary individual income tax rate.
If you held the cryptocurrency for more than a year before using it, however, long-term capital gains tax rates apply. These are lower than standard income tax rates in the US: 0 percent long-term capital gains tax for those in the 10 to 15 percent income tax bracket; 15 percent long-term capital gains tax for those in the 25 to 35 percent income tax bracket; and 20 percent long-term capital gains tax for those in the 39.6 percent tax bracket.
Obviously, you pay less in capital gains tax if you hold onto your cryptocurrencies for more than a year. On the other hand, you also lose out on long-term capital loss tax deductions if you go this route. That’s because capital losses of any kind are limited to the year’s total capital gains plus as much as $3,000 in income.
Understanding how cryptocurrency transactions incur taxes
In the realm of cryptocurrencies, many different types of transactions can incur a tax liability. Here are some of the main ways Bitcoin transactions lead to taxes.
Some users personally mine cryptocurrency and then sell it to a third party or parties. Others mine the cryptocurrency and then use it to purchase goods or services. The IRS sees both of these situations as similar to running a business and incurring expenses.
The value from the cryptocurrency is taxed as business or personal income, and you can deduct expenses you incurred mining it – things like the cost of the computer hardware and electricity you consumed in the mining process. For example, if you mine 100 bitcoins and sell them for $500 each, you have to report the $50,000 taxable income, and then factor in all of your deductible expenses.
Even if you don’t mine cryptocurrencies, if you use them in transactions, you’re incurring tax liability. If you buy Bitcoin or other cryptocurrency from someone and resell them, or use them to purchase goods or services, the IRS sees your cryptocurrency activity as investments in an asset – putting you back in the realm of capital gains tax, explored above.
For example, if you bought 10 Bitcoins for $300 each in 2017, and spent one Bitcoin on goods worth $500, you’re an investor who has gained $200 on one Bitcoin during the year or holding period. If you held that Bitcoin for longer than one year, you will incur long-term capital gains tax. If the holding period was less than a year, you’ll incur short-term capital gains tax on that $200 you earned by exchanging the Bitcoin.
Complex filing issues
Cryptocurrency taxation and reporting gets even more complex in some situations. First, determining fair market value of cryptocurrency sale and purchase transactions is very difficult. Cryptocurrencies, including Bitcoin, remain volatile, so even in a lone trading day, a massive fluctuation in prices is possible.
Moreover, the IRS expects that you report income, assets, and other figures consistently. If you calculate sales using the day’s high price, for example, you should do the same for purchases. To reduce tax obligations, frequent cryptocurrency investors and traders may use “last in, first out” (LIFO) or “first in, first out” (FIFO) accounting methods.
Cryptocurrency and Bitcoin users may also need to file a Report of Foreign Bank and Financial Accounts (FBAR). Specifically, taxpayers must report any foreign accounts that exceed certain thresholds at any time during the relevant tax year. The threshold is $10,000 in aggregate for FBAR, and it can apply to foreign Bitcoin exchanges and wallets.
The IRS is prioritizing identifying cryptocurrency users
If you’re still under the impression that cryptocurrencies are untraceable, it’s time to disabuse yourself of that idea. In fact, the IRS cooperates with blockchain businesses to identify users of Bitcoin and other cryptocurrencies. Chainanalysis, a blockchain advisor to the IRS, uses machine learning, open source references, and pattern recognition to comb through cryptocurrency transactions for suspicious activity.
The IRS is looking for hidden income, and illicit transactions such as money laundering and drug sales. In other words, their priority is smoking out people using digital currencies to commit crimes. Tax evasion isn’t even their top priority – but they find tax evaders anyway, because the same investigatory techniques reveal anyone concealing cryptocurrency assets and income.
The IRS also knows about “tumblers,” also called “mixers.” These tools for anonymizing transactions mix funds to obscure them. However, while Bitcoin mixers may slow down IRS investigations or complicate them, the agency is well aware of them, and they won’t stop the IRS from identifying cryptocurrency transactions and tying them to users.
Finally, it’s worth noting that recent changes in the law are targeting virtual currency exchanges. Their purpose is to prioritize cryptocurrency tax compliance and to identify individual users. Users with unreported cryptocurrency transactions worth more than $20,000 are at the highest risk for audits, and may even face criminal investigations.
Cryptocurrency and 1031 exchanges
Cryptocurrency such as Bitcoin might have qualified for 1031 exchange treatment under old tax law, but the new Tax Cuts and Jobs Act of 2017 ends that possibility. Under the new law, section 1031 now only applies to real property. This means that trades of digital currencies do not qualify for 1031 “like-kind” exchanges.
Tying it all together
If your history of compliance with cryptocurrency taxation and reporting requirements concerns you, it is critical for you to know the facts and cover all of your options with an IRS Bitcoin tax lawyer. For a consultation with an experienced tax attorney who understands cryptocurrency, contact the Tax Law Office of David W. Klasing.
Curious about what the landscape for cryptocurrency and Bitcoin tax law looks like? We’ve created a visual representation of the basics for you, here in one place:
Reporting cryptocurrency on your taxes
- Cryptocurrency and Bitcoin users must report income, both domestic and foreign, from all digital currencies
- Cryptocurrency and Bitcoin users may also need to file an FBAR
- When trading virtual currencies yields capital gains, you must pay taxes on those gains; the rate is determined by how long you hold the cryptocurrency
- Short-term capital gains on cryptocurrency are usually taxed like ordinary income
- Capital gains on cryptocurrency that were held for more than one year are long-term gains and are ordinarily taxed at a lower capital gain rates
The IRS is working hard to identify non-compliant cryptocurrency investors & businesses
- The IRS cooperates with blockchain brokerages to identify investors/users of cryptocurrencies
- Chain analysis, a blockchain advisor to the IRS, uses machine learning, open source references, and pattern recognition to identify suspicious activity among cryptocurrency transactions investors users and businesses
- The IRS is looking for hidden taxable cryptocurrency business or investment income, and illicit transactions such as money laundering and drug sales
- The IRS knows about “tumblers,” also called “mixers,” which mix funds to obscure them; Bitcoin mixers may complicate or delay IRS investigations but won’t prevent detection
- New laws roll out in May that will target virtual currency exchanges like Coinbase; part of their purpose, though, is to identify individual users and prioritize cryptocurrency tax compliance
- Users whose unreported Bitcoin transactions exceeded $20,000 are most likely to face audits or even criminal tax investigations and subsequent potential for tax evasion prosecution
Cryptocurrency and 1031 exchanges
- Bitcoin does not qualify for like-kind exchange under Section 1031
- Section 1031 now only applies to real property
If you are concerned about your history of tax noncompliance with cryptocurrency reporting requirements it is crucial for you to explore your alternatives with an IRS Bitcoin tax lawyer as soon as possible. Contact the Tax Law Office of David W. Klasing for a reduced rate initial consultation with an experienced cryptocurrency tax attorney.