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As Bitcoin is becoming more common, more and more taxpayers have questions about how their Bitcoin will affect their tax situation. In the past, there were some questions as to how a digital currency fits into the IRS code, however, the IRS has been making a bigger effort to make sure that cryptocurrency owners are responsible for their US tax obligations.
Bitcoin is treated as other sources of taxable income and is based on how it is used or held. Selling, buying, or exchanging Bitcoin has tax consequences. In other words, you must pay taxes for exchanging, selling, or using Bitcoin buy services and goods. But taxes can be triggered when it is exchanged, sold, or used to purchase services and goods. In some cases, just spending it could be seen as a profitable investment and is thus taxable. Bitcoin tax is reportable on your income tax return, normally due on the 15th of April each year unless you request an extension from the IRS for 6 months.
The IRS classifies Bitcoin as property. Not cash, currency, or money. That means it treats Bitcoin like sales of stocks and investments. Anyone who holds Bitcoin as a capital asset must treat them as property for tax purposes. General principles applicable to real property transactions apply to Bitcoin as well. Gains or losses from the sale or exchange of Bitcoin is taxed as a capital gain or loss. As such, it follows the same tax rate of capital gains and losses that other assets are subject to when you trade any holdings, realizing a gain or a loss. Therefore, taxpayers transacting in Bitcoin may have to document everything so that they can be reported accurately on tax returns.
Just like other types of property, you often acquire Bitcoin by exchanging it for cash. Capital gains tax comes into the picture when you eventually sell it, trade it, give it away or dispose of it. Four things occur. Number 1, income is realized if there is any gain. Number 2, the gain is measured by the dollar value between the purchase rate and the gross proceeds received from selling or disposing of Bitcoin. Number 3, the tax rate that applies is based on whether Bitcoin was held for more or less than a year. Number 4, disposing of Bitcoin must be reported on your return using Schedule D on Form 4797 or Form 8949.
There may be a net investment income tax of 3.8% on your investment income. It is due if your overall modified adjusted gross income is more than $200,000 and you’re single. For married couples who file jointly, the threshold increases to $250,000. For married couples who file separately, it drops to just $125,000. This additional tax rate of 3.8% applies only to investment income, but not wages or self-employment income earned as Bitcoin.
For each Bitcoin transaction, you must know the price you paid to buy the Bitcoin, the date you exchanged or sold the coins, and the value in dollars the Bitcoin was worth at the time of exchanging or selling it. These details will help you in your tax strategies so that you can minimize your taxes on Bitcoin-related transactions. Following are the three Bitcoin tax reporting steps.
Typically, when you sell real stocks, your broker will send you the 1099-B Form at the end of the year that includes all of the necessary details to report those sales on your return. But the same service cannot be expected from a Bitcoin exchange. If all of your transactions took place on a single exchange, it should be relatively easy to gather the information you require for tax reporting. But if your Bitcoins are scattered over several exchanges, you’ll have to download separate reports from each exchange platform. Mind you, tracking cryptocurrency transactions can be challenging. The best bet is to talk to a tax professional or a CPA familiar with cryptocurrency tax reporting. There is software available which can help you keep track of your transaction.
Once you have all the information on your cryptocurrency activity for the year, you need to decide whether you incurred a loss or a gain on each transaction. For that, you’ll need to determine which method you’ll use for valuation. Your method options are FIFO or specific identification. For the FIFO method, the coins you buy 1st are the ones to sell 1st. For the specific identification method, you choose which coins you’re selling off in each transaction. The amount of taxes you owe would be impacted by the method you choose.
Capital gain transactions should be reported on Form8949, which is divided into 2 sections. Those Bitcoins that are held for 1 year or less belong to the short-term section of the form. Short-term gains in cryptocurrencies are charged the same tax rates as ordinary income, with 37% being the top rate. Cryptocurrencies held for longer than a year belongs to the long-term section of the form. Long-term gains attract more favorable rates, capping at 20%.
The IRS Form 1040 for the year 2020 includes a question of whether you’ve received, sent, sold, acquired, or exchanged a financial interest in any digital currency. If you check no when you did engage in cryptocurrency transactions, that can be considered as a willful attempt to evade taxes. You may shrug your shoulders and say that you were not aware that you were supposed to report them. But the IRS will know about your crypto movements because they can check and confirm them as all Bitcoin transactions are stored in the Bitcoin network permanently, which is public.
If you pay your employees in Bitcoin, you have to convert them into USD as of when they are made and record them because they are treated just like dollar wages. You must report their earnings to the IRS on W-2 forms. Similarly, employees have to report their total wages in dollars, if they are earned in Bitcoin.
Self-employed people who receive Bitcoins as payments for sales transactions must convert Bitcoin to the current value of dollars when they were received and report the figures. You must include that as gross income. Also, you’ll have a loss or gain if you dispose of them because it’s considered as property for tax purposes.
If the IRS finds out about your omission, you’ll receive a notice and could face tough penalties. You’ll be charged a 0.5% interest rate for the tax amount you owe, up to a maximum of 25% of the balance. As of 2020, you’ll also be penalized at a 5% rate every month. The IRS has numerous collection options, from levies on your bank accounts and income to liens against your property.
In the recent revenue ruling, the Internal revenue service clarified the tax treatment of digital currency transactions. They have issued guidance notice on how tax should be treated for businesses and individuals using virtual currencies. It also published frequently asked questions on digital currency transactions for people who hold cryptocurrency as an asset but are not particularly involved in the business or trade of selling cryptocurrency.
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