About Bitcoin Income Tax
Lately, I’m starting to be asked about bitcoin income tax implications for 2017 by some who follow my posts, Facebook page and Tweets. End of year is quickly approaching and those realizing tremendous gains from Bitcoin should prepare for the tax-man well in advance of tax time. Be prepared so that the fun of these all-time-highs doesn’t get you hit with a bucket of cold water some tax time!
Bitcoin is classified as a capital asset, because capital gains treatment applies only to capital assets. The definition of a capital asset includes all forms of property by default, unless specifically excluded. The list of excluded property under § 1221(a) of the code does not show bitcoins excluded by name, nor would they fall within any of the excluded categories. (Understand that this is not true if bitcoins are held as inventory in a trade or business, which might be the case if you mine bitcoins, nor is it true if bitcoins are classified as a self-created intangible asset like a copyright or artistic composition, which is unlikely but possible).
Therefore, bitcoins are a capital asset in regards to most taxpayers and qualify for capital gains treatment. If you were lucky enough to buy your bitcoins more than a year ago, then your gains would qualify for the lower preferential tax rate given to long-term capital gains (probably 15%, but it depends on your income level). If you held you bitcoins for one year or less, then the gains are characterized as short-term capital gains, which are taxed at ordinary income tax rates – the same rate as your paycheck.
While it is true the IRS only knows what it is told about your bitcoin gains – you might want to consider these four ways the IRS can find out (others may exist also).
First, your bitcoin exchange (i.e. Coinbase) or payment processor (i.e. debit card, PayPal) may report your transactions to the IRS. This would be done with a Form 1099, which we have all encountered one time or another in different employment situations. Currently, it does not appear that bitcoin transactions are subject to the 1099 reporting requirements (although that will probably change). Therefore, unless these entities voluntarily file a 1099 against you, it is unlikely that the IRS will receive a report of your bitcoin transactions. They would need your social security number in order to file a 1099 in your name.
Apparently, if you buy or receive Bitcoin on an exchange (i.e. Coinbase, Bitstamp, etc.) there is a transaction recorded that is a taxable event. If you acquire Bitcoin sent directly to an offline wallet – there is no recorded transaction. If you send Bitcoin to a bitcoin debit card (i.e. BitPay, Shift, etc.) transactions are recorded and become taxable events.
Sidenote: IRS Notice 2014-21 clarifies that “payment settlors” who convert bitcoin payments to cash for merchants do have to file 1099s. IF you are not a merchant, then this does not impact you.
Bitcoin Income Tax Red Flags
Second, your BANK or bitcoin exchange might file a Suspicious Activity Report (“SAR”). US banks and bitcoin exchanges are required to file SARs for wire transfers that are “suspicious” and larger than $5,000 ($2,000 in the case of bitcoin exchanges). The meaning of “suspicious” is very vague and highly discretionary. Out of an abundance of caution, many banks automatically treat all international transfer as “suspicious.” So, if you’ve sent or received a wire transfer of more than $5,000 to/from an international bitcoin exchange like Bitstamp, CEX or BTC-e, you can be pretty sure that your bank has already filed a SAR against you. The banks are prohibited from telling you if they did, so you’ll never know for sure. The larger and/or more frequent SAR filings are regarding you, the more likely they will become a legitimate red flag and trigger an investigation or audit. Although FinCEN is generally concerned with money laundering activities, the IRS does have access to FinCEN filings and it is common for IRS special agents to participate in FinCEN investigations.
Bitcoin Tax Rats
Third, someone can rat you out to the IRS. This happens far more often than one might think. The simple fact is that people get jealous, and if they’ve heard you made lots of tax-free money with bitcoin, they might be tempted to ensure “justice is served”. There’s also that nice reward the IRS will pay them for snitching if it results in taxes owed, penalties and interest from you.
Bitcoin Income Tax Best Practice
Fourth, you voluntarily and accurately report bitcoin gains on your tax return.
You might think I’m nuts for saying that, but there are a lot of very rich people in prison who used to think hiding their Swiss bank accounts was a good idea. The fact is penalties for failing to report income are significant and carry the possibility of criminal prosecution.
At the end of the day, we all have a decision to make. Comply with the law and pay the taxes. Or violate the law and worry about getting caught. If caught, the amount of money you’ll spend on legal counsel, and pay in penalties and interest, will drastically exceed the amount you saved. Not to mention the possibility of a felony criminal conviction and a prolonged stay at Club Fed. Personally, nothing is worth jeopardizing my peace-of-mind to the point where I cannot enjoy life over a few bucks. I will pay the taxes – as unpleasant as that might be.
Bitcoin Income Tax for Mining
IRS Notice 2014-21 clarifies the treatment for bitcoin miners. Specifically, miners must report income for each bitcoin mined during the taxable year. The amount of income is equal to the market price of Bitcoin on the day it is awarded the miner on the blockchain. This also becomes the basis for the bitcoin going forward and will be used to calculate gain/loss in the event the bitcoin is sold. Mining expenses (i.e. electricity, equipment, etc.) would not be included in the tax-basis. Instead, these costs would be deductible in the taxable year as an expense. Miners must determine if their mining activity rises to the level of a trade or business, which is a highly factual determination. If your mining operation is substantial and continuous enough to be considered an actual business, then you can deduct all of your ordinary and necessary expenses. This would include the cost of electricity and depreciation on your mining rig, among others. If your mining operation is not substantial or continuous, you would deduct expenses the same as an ordinary investor.
Bitcoin Income Tax for Day Traderslike
Usually, the tax treatment for day traders is the same as a regular investor. There is the possibility of your day-trading activities rising to the level of an actual business (which would make your gains and losses “ordinary.”) The IRS doesn’t easily classify day-traders in this manner, so it’s unlikely you have anything to worry about here. However, you should consult with a tax advisor to be sure about your status if trading has become your business. You are permitted to deduct investment related expenses as an “itemized deduction” as an investor. However, this deduction is fairly meaningless for most investors because one must actually itemize deductions instead of taking the standard deduction, which many taxpayers do not.
Bitcoin Income Tax on Services/Goods
If you sell goods or services and accept bitcoin as payment, your basis in those bitcoins is equal to their fair market value at the time they were received. Generally, this is determined by reference to the average market price on that day. For example, if you wrote a software program for someone and received 1 BTC as payment on November 1st, your basis in those bitcoins is equal to the average price of 1 BTC on that day.
The choice of which exchange used is up to you (i.e. Coinbase, Bitstamp, Bitfinex, etc.), but whichever exchange you choose, you should have a reasonable explanation for your choice. You should also stick with that choice when computing your gains in the future. Arbitrarily picking exchange prices that best suit your tax interests will not be acceptable to the IRS in the event of an audit.
Bitcoin Income Tax Records
The IRS requires that you maintain records sufficient for determining the amount of your gain or loss, as well as the holding period of your bitcoins. This is a flexible standard and depends on the circumstances. Ideally, you should maintain a log of all your bitcoin acquisitions and dispositions, including the price, date, and related address of each transaction. Exchanges such as Coinbase make this information available as a downloadable spreadsheet – so it is recommended that you locate such now, download and save it for tax season. Remember – you are required by law to maintain records, and failing to do so will result in civil penalties if you are subsequently audited and owe additional tax.
Note: The info in this post is not meant to be taken as professional tax advice. You should consult your tax professional for advice specific to your income tax liability. This information is provided merely for the purpose of discussion and consideration.
Bitcoin Income Tax Calculator
Here is a link to a bitcoin tax calculator to help estimate capital gains for estimation purposes. Consider CoinTracking to analyze all your trades and generate real time useful information such as the profit/loss of your trades, the value of your coins, balances, realized and unrealized gains, reports for tax declaration, and much more.
- Virtual currency “does not have legal tender status in any jurisdiction.”
- “Virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency, is referred to as ‘convertible’ virtual currency.”
- “Bitcoin is one example of a convertible virtual currency.”
- “Bitcoin can be digitally traded between users and can be purchased for, or exchanged into, U.S. dollars, Euros, and other real or virtual currencies.”
- “For federal tax purposes, virtual currency is treated as property. General tax principles applicable to property transactions apply to transactions using virtual currency.”
- “A taxpayer who receives virtual currency as payment for goods or services must, in computing gross income, include the fair market value of the virtual currency, measured in U.S. dollars, as of the date that the virtual currency was received.”
- “Transactions using virtual currency must be reported in U.S. dollars” on the tax return.
- “Taxpayers will be required to determine the fair market value of virtual currency in U.S. dollars as of the date of payment or receipt.”
- “If a virtual currency is listed on an exchange and the exchange rate is established by market supply and demand, the fair market value of the virtual currency is determined by converting the virtual currency into U.S. dollars … at the exchange rate, in a reasonable manner that is consistently applied.”
When bitcoins are sold or disposed of – since bitcoins are property, the rules that apply to dispositions of property are followed. When property is disposed of, four things happen:
- Income is realized from any gains on the property.
- Gain is measured by the change in the dollar value between the cost basis (the purchase price) and the gross proceeds received from the disposition (the selling price).
- The tax rates that apply depend on whether the property was held for a short-term or for a long-term duration. And finally,
- Dispositions of property are reported on the tax return using Schedule D & Form 8949 or Form 4797. These forms require us to “show our math” when calculating gain or loss.
- Establish a record-keeping system.
- Keep track of when you acquire and when you dispose of bitcoins.
- Record dispositions of bitcoins on Schedule D and Form 8949.
- Each purchase using bitcoin is two transactions in one: an implied disposition and an expense.
- Create and maintain an accurate record-keeping system.
- Record dispositions of bitcoin on Schedule D and Form 8949.
- Identify your cost basis method.
- Identify your exchange rate (see more above on this topic).
- Keep separate wallets for short-term trading, long-term buy-and-hold positions, and personal spending.
- Normal capital gains strategies apply: offset gains with losses, time dispositions to qualify for long-term treatment, harvesting losses, and harvesting gains.
- Watch the tax rates: gains subject to the 3.8% net investment income tax.
- Identity the tax treatment for bitcoins received by “mining” them – may be business income subject to the income tax and self-employment tax.
- Deduct any investment-related expenses (Schedule A).
- Deduct any investment interest (Schedule A).
- Deduct tax preparation and advisory fees related to determining the tax treatment of bitcoins (Schedule A).
- Elect Market to Market trading? This would mean all gains are short-term and reported on Form 4797, and any bitcoin-related expenses are deducted on Schedule C.