Back in 2014, the IRS announced it was coming for your Bitcoin and other cryptocurrency holdings. At first, the law had little teeth. But as we’ve seen in the past few years, the IRS is now using its powers to find and request records from wallets and other providers to all but guarantee that the IRS will find out about your balance.
Unfortunately, the IRS considers the taxation part of Bitcoin to be simple: you must pay income tax and/or capital gains tax. If you lose money, you can write off the losses. But again, as we all know, cryptocurrency, in general, and Bitcoin specifically, don’t fit neatly into the IRS’s little “Income” or “Property” boxes.
You have to declare your cryptocurrency holdings on your taxes, but what does that mean in practice when it’s time to fill out your paperwork? Let’s take a closer look at how Bitcoin is taxed and what may be coming in the next few years.
How the Bitcoin is Taxed as Income
Do you receive Bitcoin as income for goods and services, either from an employer or as an independent contractor? Income tax applies to any virtual currency used to pay for goods or services. In other words, you can’t accept Bitcoin as an attempt at a workaround — not anymore.
The same income tax rules apply to virtual currencies as they do to payments in fixed currencies. However, there are strict record-keeping rules that both you and your employer need to follow if you don’t want to find yourself in a tax jam come April.
On every pay date (or invoice/receipt date for freelancers), you must convert the Bitcoin value to U.S. dollars and record the amount. These records will inform your tax returns, so it’s important that they’re accurate (sometimes down to the hour given Bitcoin’s massive swings in value). You’ll need to report earnings on your tax return in dollars, not in cryptocurrency, and you may need to provide your records if you are audited.
Employers: you still need to pay payroll tax even if you pay in Bitcoin. So you need to be setting enough aside in U.S. dollars — not Bitcoin — to cover those taxes. A payroll calculator can help you determine how much that should be.
Do you mine Bitcoin? You need to report it along with your gross income. If you’re a W-2 employee, then any mining productivity over $600 goes on a 1099. If you’re already self-employed, then you’ll add it to your total income.
Capital Gains Tax Can Also Apply
Taxation of Bitcoin is simplest when it’s sent or received as income and immediately transferred into fixed currency, like USD or Euros. As more and more vendors accept Bitcoin as payment, it may be tempting to hold onto cryptocurrency in its current form, especially if you’re an investor.
If you hold Bitcoin or another virtual currency in its original form, then the IRS treats it as property, even if you originally received it as income. The same tax principles as apply to any other financial instrument apply: you need to report capital gains or losses and pay the relevant taxes. In this way, Bitcoin is no different from receiving payment in equity.
Americans who live outside the U.S. need to be particularly careful with this rule. Remember that all Americans need to file income taxes, so even if you’re abroad and you make your income on cryptocurrency trading, you still have a tax liability.
Beware of Bitcoin Tax Ambiguities
By now, you understand that the interaction between cryptocurrencies and the tax system is largely the same as other assets with the exception of the stricter bookkeeping measures. But as cryptocurrency investors know, nothing about Bitcoin is as simple as just “having” it. The way that Bitcoin operates within the blockchain means that there are huge problems inherent in the IRS’s treatment of cryptocurrency.
The biggest issue with the tax policy lies in forking and airdrops. There’s no analogy between forking and anything else covered by IRS tax policy. Yet, a hard fork is still taxable income: the big fork to Bitcoin Cash faced this exact issue. But what’s particularly puzzling is the treatment of airdrops. The latest IRS guidance specifically says: “if a hard fork is followed by an airdrop and you receive new cryptocurrency, you will have taxable income in the taxable year you receive that currency.”
In other words, you could owe tax on currency that’s not yet traded. And if you receive the asset via an airdrop that you don’t ask for, then you still have to declare and pay tax on it, even if it’s not openly traded and even if you make an immediate loss on it. This is an even bigger problem because you can only use $3,000 in capital losses deductions each tax year.
Crypto Tax is Subject to Change
The issues with the current tax guidance are many, and they almost discourage anything more than dabbling in Bitcoin because you have little to no protection from exchange volatility. What’s more, the IRS Criminal Investigation team has made it clear that they are working hard to ensure that crypto holdings don’t get sent offshore where they can hide.
Even as you begin to grapple with the implications of current advice, it’s important to remember that cryptocurrency tax is subject to change. The present U.S. Treasury Secretary has suggested the Trump Administration is no friend of cryptocurrency. And given the uncertainty of the election year and the 2020 election now being months away, Bitcoin’s future as an openly traded asset is more precarious than ever.
If you don’t have an accountant who understands cryptocurrency and how it impacts the overall tax strategies of both individuals and businesses, then there’s no time like the present to find one. While no one knows what’s coming next, the past indicates that it’s going to be a bumpy ride.
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