Cryptocurrency is mainstream now. Banks and Paypal accept it already or will soon. So what does this all mean for your taxes? How do you turn bitcoin gains in capital gains? How do you avoid paying the higher ordinary income tax rates? How do you legally report your gains–and losses? Let’s find out.
Bitcoin, Cryptocurrency (“Crypto”) and Taxes
By now you’ve probably heard of the term Bitcoin (BTC), but you still don’t know what Bitcoin is: a virtual currency launched 2009. Virtual currencies have another more familiar name: cryptocurrencies or simply crypto. Since then more and more places are accepting Bitcoin (e.g. Overstock.com, Starbucks in Japan, Paypal starting in 2021). So you may want in on crypto but first you want to know how the taxes work. Below we are going to outline the various things you should know about Bitcoin and your taxes.
What is Cryto/Virtual Currency?
Crypto/Virtual Currency is a type of unregulated digital currency only available in electronic form. It is not tangible (i.e., you cannot hold it in your hands). It has to be stored and traded through electronic software.
The IRS and Crypto
The first transaction in commerce regarding Bitcoin was in 2010 of 10,000 BTC for 2 Papa John’s pizzas. To bad they were hungry, because today that 10,000 BTC would be worth about 180 MILLION dollars. Since then more and more places are accepting Bitcoin (e.g. Overstock.com, Starbucks in Japan, Paypal starting in 2021). Since bitcoin is an unregulated currency that doesn’t go through traditional banks, the IRS felt it had to move quickly by issuing some tax guidance.
In 2014 the IRS issued: Notice 2014-21 stating, Virtual currency is a digital representation of value that functions as a medium of exchange… Importantly, the IRS stated that virtual currency is property, not a currency. They were very keen to do this, so that bitcoin would fall under similar taxable categories of personal property, such as stock, bonds, etc., and be subject to tax (i.e. “…[Bitcoin] does not have legal tender status”).
The IRS and Future Enforcement
Between 2013 and 2015 only 800 people reported crypto and bitcoin transactions on their tax returns. This concerned the IRS, causing them to now step up enforcement. With the 2020 tax return year, you now have to tell the IRS if you own any Bitcoin at all, regardless of taxable events, on the front page of your tax return.
Taxable vs Nontaxable events in Bitcoin
In most common cases, the IRS sees crypto transactions as a Capital Gain or Loss transaction. In other words, “when a coin or token is sold, exchanged or used to purchase goods or services, a capital transaction occurs, resulting in a profit or loss from every transaction.” Below is a chart of taxable vs non-taxable events
|TAXABLE VS NON-TAXABLE
|Purchases / Sale for investment
|Transfer out of exchange
|Payment for goods & services
|Hard or Soft Forks
|Coin to Coin Exchange
|Receipt of coins as gifts / sales
Capital Gains vs Ordinary Income
The type of income you want to recognize from crypto, is Long Term Capital Gains (similar to the purchase and sale of stocks you’ve held over a year). However, if you receive your Cryptocurrency through “mining”, that income may be recognized as ordinary income similar to running any other business.
Taxes as a Bitcoin Miner
If you decide to become a bitcoin miner, your taxes will be at ordinary income rates. However, you will be able to deduct mining expenses. Some of these are cost of your computers, electricity, cost of internet, and any other ordinary expenses that were used to mine your bitcoin (we will be writing more about the treatment of Bitcoin as a business in the future, we will link it here once it’s published.)
Why it is important to maintain separate accounts for personal vs investments in Crytocurrency.
It is very, very important to never commingle your personal use Bitcoin with Investment Bitcoin. This is because personal property that loses value is not entitled to a deduction or loss on your taxes.
Example: you purchase a personal use car to drive to and from work for $10,000. Four years later you sell it for $2,000. You are not allowed a deduction of an $8,000 loss since this was a personal use vehicle. However, let’s say you buy a 1967 Mustang for $25,000 as a collectible investment, you come across hard times due to a recession and sell it at a discount for $20,000. You would be able to claim the $5,000 loss (providing that you can prove it was only an investment vehicle).
Bitcoin / Cryptocurrency is the same. Let’s say I purchase some Bitcoin on Coinbase as an investment, but I commingle the investment wallet with the wallet I use to purchase items on Overstock.com. The IRS may take the position that any loss of value to your Cryptocurrency was a personal loss, not an investment loss and may deny you your loss deductions. It is very important to keep your Bitcoin investments and personal purchases using Crypto separated.
As Crypto becomes more and more accessible as a medium of exchange, expect the IRS and Congress to continue updating and passing new legislation regarding how Bitcoin and other virtual currencies should be reported for taxes.