Bitcoin and other cryptocurrencies have become some of the most popular investing trends over the past few years. In fact, recent data shows that as many as 14% of Americans hold cryptocurrency in their portfolio.
Read More: The Craze for Cryptocurrency
Unfortunately, many people dive into Bitcoin investing without fully understanding the tax consequences. And in 2019, the Internal Revenue Service (IRS) announced it would be sending letters to more than 10,000 taxpayers who may have failed to report crypto transactions over the previous tax year.
Before you begin investing in Bitcoin — or any investment, for that matter — it’s important that you understand exactly what taxes you might be subject to.
Cryptocurrencies are Property
In 2014, the IRS issued a statement clarifying that for tax purposes, Bitcoin and other virtual currencies would be treated as property rather than currency. The IRS definition of virtual currency is “a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value.”
So what does this mean for tax purposes?
Essentially it means that Bitcoin transactions will be taxed like other properties such as stocks, bonds, real estate, and more. Because of this classification, Bitcoin investors may find themselves subject to capital gains taxes.
The IRS requires that you pay taxes on Bitcoin transactions, just as you would for transactions involving any other valuable asset. Taxable Bitcoin events include:
- Receiving mined Bitcoin
- Selling Bitcoin
- Using Bitcoin to pay for goods and services
- Using Bitcoin to buy another cryptocurrency
- Being paid with Bitcoin
- Receiving Bitcoin rewards
It’s critical that you maintain documentation of any Bitcoin transactions you have throughout the year so you can file them appropriately on your taxes. If you need to report Bitcoin transactions, it might be best to hire an accountant to prepare your taxes to ensure everything is accurate.
Paying Taxes on Bitcoin
The most common taxes you can expect to pay on your Bitcoin transactions are capital gains taxes, which apply when you sell an asset for more than you bought it. They also apply when you use your Bitcoin to purchase another good or service. After all, the IRS has made it clear that cryptocurrencies such as Bitcoin are classified as property, not as currency.
The type of capital gains taxes you pay will depend on how long you hold your Bitcoin before you sell. If you hold your Bitcoin for less than one year and then sell for a higher price, it’s a short-term capital gain you’ll be taxed at your normal income tax rate.
If you hold your Bitcoin for more than one year and then sell for a profit, you’ll be subject to long-term capital gains taxes. Capital gains taxes rates range from 0% to 20%, depending on your household income.
While most Bitcoin transactions are likely to be classified as capital gains, there are some exceptions. For example, any Bitcoin received as rewards or payment are classified as income. You’ll receive a 1099 form and must report those earnings to the IRS.
Keep in mind that even if you don’t receive a form for every Bitcoin transaction, you may still be subject to taxes. For this reason, it’s critical that you hire an accountant familiar with the tax treatment of Bitcoin and other cryptocurrencies.
There is some good news for Bitcoin investors. Just like your gains are taxable, your losses may be tax-deductible.
First, any losses you incur directly offset your capital gains. Suppose you have a Bitcoin transaction with a capital gain of $1,000. Normally you would pay capital gains tax on those earnings. But if you had another Bitcoin transaction with a loss of $1,000 — meaning you sold your Bitcoin for $1,000 less than you paid for it — then that loss would directly offset your gain. Your gains and losses would even out, and you’d have no taxable gains.
Not only can you use Bitcoin losses to offset any gains you had, but you can also claim a net loss of up to $3,000 as a tax deduction. Let’s say you had a Bitcoin transaction with a gain of $1,000. In another transaction, you had a loss of $4,000. Not only does your loss wipe out the gain, but you also reduce your taxable income by $3,000, meaning you’ll owe less in taxes.
If you have any capital losses on your Bitcoin transactions, you’ll report them on the Form 1040 Schedule D.
What Happens if You Don’t Pay?
Failure to pay your taxes, whether it be for your Bitcoin gains or anything else, can come with serious consequences. The IRS issues penalties for a variety of reasons, including failing to:
- File your tax return on time
- Pay your taxes on time
- Provide accurate information on your tax return
The penalty for providing inaccurate information on your tax return is 20% of the underpaid amount. The penalty for failing to pay your owed tax amount is 0.5% per month, for a maximum penalty of 25% of your unpaid taxes. For both penalties, you may also be subject to interest on both your unpaid amount and the penalties.
And if you still fail to pay the amount you owe, the IRS could issue a tax lien against your property, including real estate, personal property, and financial assets.
You also shouldn’t assume that you won’t be penalized if you don’t pay your Bitcoin taxes. First, IRS penalties apply regardless of whether your misstep was intentional. Additionally, because Bitcoin transactions are public, you shouldn’t assume the IRS won’t know about your investing activities.
By failing to report your Bitcoin gains, you’re increasing your chances of being the subject of an IRS audit.
The best way to prepare yourself for tax season is to keep detailed records of your Bitcoin transactions. Even if you don’t receive tax forms from the platforms where you trade, it’s important to record exactly how much you’ve spent, gained, and lost throughout the year. When tax season rolls around, you can hand these records over to your accountant.
One simple way to track your Bitcoin gains is by using Personal Capital’s financial dashboard. It now comes with cryptocurrency tracking, which uses public data to track the value of your holdings of Bitcoin and other cryptocurrencies.
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