How Does the IRS Tax Bitcoin?
As the nation launches into 2021’s tax season, people may be asking the pressing question, “How does the IRS tax Bitcoin?” As of the past few years, Bitcoin and its crypto counterparts have dramatically increased in popularity due to many significant factors. Comprehensive surveys estimate that nearly 30 million Americans (11% of the population) currently own Bitcoin.
Though it wasn’t always taxed or regulated, with record user statistics ever on the rise, the currency has attracted recent scrutiny from the IRS; more stringent regulations and codes are being embedded into the national fiscal infrastructure. During the coming months, Bitcoin users must understand their brand new tax liabilities regarding how the IRS taxes Bitcoin and cryptocurrency at large.
How Does the IRS Tax Bitcoin?
Though cryptocurrency acts and operates as legal tender in the same way that cash or credit might, from the IRS’ perspective, Bitcoin is treated as property instead of currency, falling into the same categorical classification as stocks, bonds, and real estate. Reconceptualizing cryptocurrency as property may be confusing to taxpayers at first, but understanding the ins-and-outs of this technicality will make future tax preparations easier.
So how does the IRS tax Bitcoin, exactly? The answer differs depending on whether you’ve invested in it, used it or earned it—or engaged in any combination of the three. In most cases, merely spending, selling, or exchanging your Bitcoin can make you subject to taxation, each action saddled with federal expectations. The most important aspect is taking into account one’s yearly financial gains and losses. Continue reading to dive into the specifics outlined below.
When Does the IRS Tax Bitcoin?
The IRS taxes Bitcoin for several reasons. The first and most apparent is when the use of cryptocurrencies triggers a taxable event:
Exchanging Cryptocurrency for Fiat Currency: When Bitcoin gets exchanged for fiat (government-backed) currency (such as USD), capital gains may be taxable.
Trading Cryptocurrency for Goods and/or Services: The conversion of Bitcoin into an asset (from buying groceries to plane tickets) makes the transaction taxable.
Exchanging One Cryptocurrency for Another: Trading cryptocurrencies for any of their counterparts (i.e., Bitcoin to Litecoin) is considered disposal and is subsequently taxable.
Earning Cryptocurrency: When you make Bitcoin through mining, it is viewed as taxable income. If you earn Bitcoin through your employer, it’s treated similarly to wages and declared on a W-2 form.
Receiving Cryptocurrency for Free: Though the tax stipulations for the reception of free tokens are an ongoing open discussion, you are still required to declare all Bitcoin you have received for free. Likely you will still be held accountable for the capital gains at the point of sale of said coins.
When Doesn’t the IRS Tax Bitcoin?
You won’t be held accountable for paying cryptocurrency taxes under two circumstances:
Buying and Holding Cryptocurrency: Because this Bitcoin has yet to incur any capital gain or loss on the investment, it won’t be taxed until sold, used, or traded.
Transferring Cryptocurrency Between Wallets: Transferring Bitcoin between wallets is obviously not considered a taxable event.
How to Properly File Bitcoin Taxes
Here are some insightful tips on how best to ensure your Bitcoin taxes are accurate and in compliance with the latest IRS standards and expectations.
Acute and Detailed Record-Keeping
While fiat currency’s fixed value makes precise record-keeping less necessary, the major price fluctuations inherent in the cryptocurrency market mean that users must continuously record the cryptocurrency’s fair market value at the time(s) of purchase and disposal. When taking a proactive approach to preparing for Bitcoin taxes, keeping accurate, time-stamped records is paramount, especially considering that accounting for multiple transactions across varying exchange platforms can further complicate this process.
In some cases, your Bitcoin wallet provider will enable you to download transaction data directly, but it’s best practice to keep individual records. When it comes to cryptocurrency, all transactions, no matter how small, should be noted. Relevant data should include:
Date & time of cryptocurrency purchase
“Spot” value at the time of sale - because Bitcoin value can fluctuate dramatically in short periods, its value will have changed by the time it gets disposed of; it will either be worth more or less than it was at the time of initial purchase.
Date & time of cryptocurrency disposal. “Disposal” acts as an umbrella term for a cryptocurrency’s sale, exchange, or use.
Fair market value at the time of disposal
Keeping this information organized and on-hand will help determine gains and losses for future tax purposes.
Calculate Gains & Losses
Once you’ve compiled records containing the information listed above, you’re ready to do the math on all your transactions. Here are a few different specific identification methods (all approved by the IRS) up for consideration when determining which Bitcoin to account for come tax day:
First-In-First-Out Method (FIFO): This method selects Bitcoin according to chronology. The coins purchased first are the first to be used or sold. FIFO is the most straightforward and historically common method of calculating crypto gains and losses and is also the only usable system when there are no adequate records.
Last-In-First-Out Method (LIFO): This method selects Bitcoin according to reverse chronology. The coins purchased most recently are the first to be used or sold. LIFO can help avoid steeper tax rates on other short term holdings by ensuring that your oldest coins have time to mature into long term holdings.
Highest-In-First-Out Method (HIFO): This method selects Bitcoin boasting the highest original cost at the time of purchase. Savvy entrepreneurs view HIFO to minimize taxes as it tends to lead to the most considerable capital losses and the lowest gains.
Filing With the IRS
Despite your calculative methodology of choice (which doesn’t require official disclosure), the most important thing to note when filing with the IRS is the difference between short-term and long-term holdings. Though the exact percentages owed will fluctuate according to your tax bracket, short-term holdings are always taxed more heavily than their long-term counterparts.
A CNBC tax planning report states that the difference between taxation rates can be monumental in that “long term capital gains are subject to rates of 0%, 15% or 20%, while ordinary income rates, or short term capital gains, can be as high as 37%.” A Bitcoin holding is long-term if maintained for more than a year.
Most of your cryptocurrency tax reporting will take place on the IRS 8949 tax form, which is used to detail “sales and other dispositions of capital assets.” As of a recent addendum, form 1040 will also necessitate disclosing any personal cryptocurrency transactions within the past year.
Something else to note (mainly applicable to those who may be making hundreds of Bitcoin disposals per year) is whether or not you may be subject to the 3.8% net investment income tax. This tax applies to single filers whose overall modified adjusted gross income exceeds $200,000 a year.
Hire Help if Necessary
In most cases, further research will be necessary to determine your official financial obligations; contracting a CPA or tax professional that specializes in cryptocurrency proceedings is always a trustworthy option. Alternatively, plenty of new websites and services that are crypto-specific are sure to know the ins and outs of tricky tax statutes and regulations. Visit the IRS’ virtual currencies FAQ page to continue more self-directed learning.
Don’t Skirt Your Crypto Tax Obligations
Though one of Bitcoin’s greatest assets is its emphasis on personal anonymity, all transactions involving Bitcoin are transparent; they get stored publicly and permanently on the Bitcoin Blockchain. The keeping of transactions means that the IRS can potentially find out if you neglect to pay the crypto taxes that you are accountable for, even if you weren’t aware you were responsible for them in the first place.
Paying close attention to the question, “How does the IRS tax Bitcoin?” will ensure you steer clear of any extreme repercussions including, liens on your property, steep interest rates, and penalty charges, or in severe cases, criminal prosecution. In 2019, the IRS sent 10,000 letters of warning to taxpayers who either neglected to or improperly reported their digital cryptocurrency holdings.
Review Your Bitcoin Transactions With Pelicoin
With Pelicoin’s extensive ATM network spanning the entirety of the Gulf Coast, you’re able to easily and securely convert Bitcoin into hard cash to use in your everyday transactions. Pelicoin ATMs also enable you to buy Bitcoin, Litecoin, or Ethereum on the go!
But after answering the question, “How does the IRS tax Bitcoin,” you’ll know to keep a close record of your transactions as they are liable to be federally taxed later on. Contact us today at support@pelicoin.com or consult our FAQs to learn more about how Pelicoin ATMs can help you understand cryptocurrency exchange best practices.