Cryptocurrency and the IRS: What you need to know
Cryptocurrency. It has become a hot topic these days and continues to grow in popularity. But what does it mean for your tax return?
Whether you’ve used cryptocurrency as an investment or as a currency, you owe taxes on it. Your Bitcoin holdings are not taxable (yet), but once you sell them or use them to buy something, you have realized a capital gain/loss and need to report that to the IRS.
Some common tax terms that you should know:
- Capital Assets: Capital assets are everything you own such as houses, furniture as well as cryptocurrency.
- Basis: The amount you spent on cryptocurrency including all fees you paid
- Realized Capital Gain or Loss: When you cash in, the profit or loss you made on the cryptocurrency [Profit/Loss = Sold Price-Basis]. You can deduct losses on cryptocurrency selling.
- Unrealized Gain or Loss: The profit or loss you have on paper but have not actually cashed in on. No taxes on unrealized gains until you sell it.
- Short-term Gain: Realized gain on cryptocurrency held less than 1 year before selling it.
- Long-term Gain: Realized gain on cryptocurrency held longer than 1 year before selling it
How Cryptocurrency is Taxed:
The IRS has ruled to consider Bitcoin or other cryptocurrencies as capital assets, which means if you buy cryptocurrency at a price and sell it at a higher price, IRS will collect taxes from you on gains you earned. For instance, if you bought $2,000 in cryptocurrency and it appreciates to $4,000, you will not be taxed until you sell it or spend it. But the tax you owe to the IRS on this transaction doesn’t just magically get paid. You have to report it on your annual taxes.
The tax rate on cryptocurrency taxes is based on the length of time you’ve held it.
- If you have held the cryptocurrency less than a year, it is taxed as a short-term gain. Short-term gains are taxed as regular income, which means the rate is equal to your federal income tax bracket.
- If you have held the cryptocurrency longer than a year, it is taxed as long-term gain with a lower rate but still based on your income level.
- If you fall into top three highest income brackets (39.6%. 35%. 33%), you also must pay a 3.8% tax on net investment income.
How to Report Basis (FIFO vs. Specific identification):
Cost basis is what you paid for an investment, including trading cost, brokerage fees and etc. It can be adjusted for corporate actions such as stock splits, mergers, and dividend payments. When you file your taxes, it is essential and your responsibility to report correct amount to IRS. Using appropriate accounting method can help you make a big difference in the amount you end up paying.
- First-In, First-Out
FIFO, or First-In-First-Out, is the default method that IRS will use and assume if you don’t provide a clear analysis of each transaction from beginning to end, buy to sell. For example, if you sold 50 shares of a 100 shareholding, the IRS will assume that the shares you sold were the oldest ones you bought. Thus, if it is a rising market, you’ll probably end up having higher tax obligations.
This is another option that you could choose. Specific identification is more flexible and can be better for your tax obligations.
For example, you bought stocks of Corporation A
100 shares in 2012 (6years ago) for $10, $50 for brokerage commission fee...Total cost: $1050; $10.5/share
200 shares in 2015 (3 years ago) for $40, $50 for brokerage commission fee...Total cost: $8050; $40.25/share
Now, let’s say Corporation A’s stock has continued to appreciate, which is now valued at $100/per share. You want to sell 100 shares at $100/share with $50 commission fee cost. Thus, the amount of taxes you need to pay depends on which accounting method you picked. (See Exhibit 2 below to understand more how accounting methods work)
This huge difference in capital gains is why it is so important to track each purchase and sell accurately. And keep in mind a sell technically occurs any time you get rid of a type of currency, so if you trade Bitcoin for Ethereum or buy a product or service with Litecoin, that is a sale transaction and should be reported to the IRS.
Where to Report Cryptocurrency income: If you earn income from buying cryptocurrency or selling it at a higher price, you need to report all the sales income on Schedule D/Form 8949 on your annual 1040 tax forms.
What if you don’t pay taxes on cryptocurrency: If IRS catches you that you didn’t pay taxes on cryptocurrency, you will be treated the same as other tax evaders. You will receive a deficiency notice from IRS, which you can either pay or contest. You might have to pay penalties including “Substantial understatement” and “negligence and disregard of the rules and regulations”. These penalties are calculated as a 20% of the net understatement of tax. In addition, if IRS thinks you knew about the cryptocurrency tax laws and rules but didn’t report it in a right way. You will be penalized an additional 75% of the underpayment due to fraud.
Ways to Minimize Cryptocurrency Taxes: Cryptocurrency has soared in value over the past year. In 2017, Bitcoin has increased by over 1700%, which means there are a large number of people who are sitting on some serious profits.
Here are two ways that could help you reduce the taxes on cryptocurrency:
Donate some cryptocurrency to charity: You can directly donate cryptocurrency to charities, which means you don’t want to sell it first and then donate. It benefits both you and the charity. If you sell it first, you need to pay the taxes on the gain, instead, the charity will receive the full value of your contribution. In addition, the benefit you can get from donating your cryptocurrencies is your tax deduction will be equal to the fair market value of the donated cryptocurrency (as determined by a qualified appraisal)
Hold the cryptocurrency to long-term (>1 year): IRS treats long-term capital gains more favorably than short-term gains. As what we mentioned above in Table 1, you could get a better tax rate as long-term capital gain.
Tools Available to Track Bitcoin Trades:
Having a right portfolio management platform is crucial for every single investor, which could provide them with real-time relevant market data, analytics, and statistics to make better and more informed decisions. Here are some tools that you could consider if you want to be hands-on with your cryptocurrency investment and trade in and out of the digital currency to generate a profit.
Written by Joy Yao, Honest Buck Tax Intern