Posted by Fred Lake

How Bitcoin is Taxed

How Bitcoin is Taxed

There are always consequences whenever bitcoin will be sold, bought, or traded. Bitcoin and other virtual convertible currencies should be treated as property, not as currency according to the Internal Revenue Service. It is not a minor distinction even if it sounds like one. It determines what tax planning techniques you can use to minimize your taxes on a bitcoin transaction, what information you will need to make sure your taxes are calculated correctly, and how bitcoins are taxed. 

Since virtual currencies are considered property for tax purposes, when you dispose of bitcoin then you will have a capital gain or a capital loss. Even if you’re paid in the virtual currency your income will still be taxable and your gain represents your income. 

You usually have two transactions in one since spending virtual currencies is another matter. You are spending the dollar-equivalent amount and you are effectively disposing of the virtual currency. 

From a Tax Perspective, What is Virtual Currency?

The IRS stated that 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. In any jurisdiction, it doesn't have any legal tender status. Convertible virtual currency is a virtual currency that has an equivalent value in real currency or that acts as a substitute for real currency. 

Bitcoin is one example of a convertible virtual currency because it can be digitally traded between users and can be purchased for, or exchanged into, U.S. dollars, euros, and other real or virtual currencies, the IRS added. 

What are the tax treatments of Bitcoin?

In Notice 2014-21, the IRS stated that Virtual currency is treated as property for federal tax purposes. 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.

It is also stated in the notice that transactions using virtual currency must be reported in U.S. dollars. Taxpayers will be required to determine the fair market value of a 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.

Virtual Currency treated as property

A tax attorney who specializes in virtual currencies, Tyson Cross wrote that: Every bitcoin transaction is taxable. Every time they purchase goods or services with bitcoin, bitcoin users will have to calculate their gain or loss. 

What does that really mean? For tax purposes, the IRS said that bitcoin and similar convertible virtual currencies are property. You first acquire property often by exchanging cash for the property and then you own that property for a period of time that typically goes as with the other types of property. You might sell, trade, give away or otherwise dispose of the property eventually.

When you acquire it, how long you hold it, and how you dispose of it are the three moments in time that are critical to the taxation of any type of property. When you dispose of it, the taxman will then come. 

When a property is disposed of, below are the four things that will happen:

  • From any gain, income is realized
  • Between the gross proceeds received from the disposition (the selling price) and the cost basis (the purchase price), the gain is measured by the change of the dollar value. 
  • Whether the property was held for a short term or a long term period, the tax rates that will apply depends on that. 
  • Using Schedule D and Form 8949 or Form 4797, your disposition of property should be reported on your tax return. When calculating your gain or loss, these forms require you to show your math. 

Let’s presume that you sell a bitcoin for $50,000 and you purchased it for $30,000, so it means that you gain $20,000. It will be a short term gain and will be taxed as ordinary income according to your tax bracket if you held the bitcoin for a year or less. But it will be a long term gain if you held the bitcoin for longer than a year and it will be taxed at a rate 0, 15, or 20 percent depending on your overall income. 

For Investors, Casual Bitcoin Users and Speculators, below are some tips. 

You should always keep a tracking record containing all your transactions from acquiring and disposing of a bitcoin. Identify your exchange rate and cost basis method. Then on Schedule D and Form 8949, record the disposition of bitcoin. 

Your income being measured accurately is ensured if you will keep detailed records of transactions. Jayson Tyra, a certified public accountant in Texas who specializes in bitcoin said that the key thing is maintaining records, substantially similar to stock. Incomplete records might as well be no records. 

Using a reputable bitcoin wallet provider should be considered by some casual bitcoin users. To make buying, trading, and selling bitcoin more secure and user-friendly, wallet providers have implemented risk mitigation tools. Investors should also take a look at wallet providers or registered investment vehicles with the kind of security features that one might expect from a banking institution apart from tax consideration. David Berger, Founder of the Digital Currency Council said that some platforms offer to ensure holdings or store holdings offline in a vault.  

Offset gains with losses, time your dispositions to qualify for a long term treatment, harvest your losses and gains are normal capital gains strategies. A tax professional can help you with these concepts. 

Gains are subject to a 3.8 percent net investment income tax so you should always keep an eye on tax rates.

All your gains are short term and you would, therefore, report them of Form 4797 if you elect market-to-market trading. On Schedule C is where any bitcoin-related expenses are deductible. 

Fred Lake
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