Bitcoin is a digital currency (also known as cryptocurrency) that relies on cryptography for its operation. The Bitcoin protocol, a system of open source processes, governs the currency and is primarily supported by a peer-to-peer network.
Unlike traditional money, it isn’t controlled by a central bank or government. Using bitcoins allows people and to transact without foreign currency exchanges. Bitcoin can be acquired trading with altcoins (Bitcoins alternatives), fiat currencies or ATMs, or by mining them using specialized software that rely on the blockchain technology to process and verify transactions.
All bitcoin transactions are recorded on Blockchain.info, a public ledger, and attributed to a particular account, or wallet. Using the public ledger, anyone can view a wallet’s transaction record. Ever since the adoption of the bitcoin as a means of a payment, user all over the world have been enjoying some of these benefits:
- Low transaction fees.
- International transferability and convertibility.
- Protection from political risks and inflations.
- Basic alternative digital currency problems of supply growth and double payment/verification solved.
- Immunity from bank failures, as miners are always ready to process transactions all over the world.
As a result of these outstanding features of the bitcoin, traders all over the world are adopting the use of bitcoin as a medium of exchange. The major condition for its mainstream adoption is no other than its ability to build the TRUST gap in transactions.
It should be noted that, the adoption of the bitcoin has business and institutional implications which may include:
- Hedging and investment services
- Ease of payment
- Retail and investment banking
- Risk and compliance
- Operations and technology
In this write-up, we’ll focus on the Bitcoin Taxes implications.
Firstly, it is important to understand a virtual currency in accordance with IRS’s definition:
According to the IRS, “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.”
Therefore, according to the IRS’s definition, the following must be understood as regards virtual currencies:
- 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.
- 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, fiat or other virtual currencies.
The adoption of bitcoin may carry numerous tax implications, among them are:
- Revenue recognitions,
- Market-to-market valuation,
- The characterization of profit and losses for tax purposes,
- The applicability of barter transaction rules,
- Basis tracking and hedging considerations.
Legitimate businesses who want to comply with the rules and do not want to be associated with tax evaders or criminal enterprises have urged the government to issue clear rules about the tax consequences of digital currency transactions.
Following a recommendation by the National Taxpayer Advocate to issue guidance on the tax treatment of the transfer of digital items and currency, the IRS created a web page that says “The Internal Revenue Service has issued guidance on the tax treatment of transactions using virtual currencies, such as Bitcoins or other similar currencies.
The sale or other exchange of virtual currencies, or the use of virtual currencies to pay for goods or services, or holding virtual currencies as an investment, generally has tax consequences that could result in tax liability. This guidance applies to individuals and businesses that use virtual currencies.”
The IRS answered some common questions about the tax treatment of Bitcoin transactions in it’s the recent Notice. Tax treatment depends on how Bitcoins are held and used.
If you are dealing with any virtual currency, here are few things you should understand about the payment of Tax:
For Federal Tax Purposes, Virtual Currencies Are Treated As Property
General tax principles applicable to property transactions apply to transactions using virtual currency. This means that bitcoin is subject to the general principles of taxation that apply to all types of property. There are no special rules or treatment for virtual currencies.
As property, bitcoin qualifies as a “capital asset” in the hands of most taxpayers. It is important to note that an exception is, if the bitcoin is held as inventory for sale in the taxpayer’s trade or business, such as being classified to be under any of these categories:
- Foreign Currency
- Share of Stock or a Security
As long as any of the above exceptions does not apply, any gain or loss realized upon exchange of bitcoin is “capital” in nature and eligible for the preferred long-term capital gains.
Any Convertible Currency Is Subject To Tax By The IRS
The sale or exchange of a convertible virtual currency—including its use to pay for goods or services—has tax implications. According to the IRS, “the sale or exchange of convertible virtual currencies (that fall in the above description), or the use of convertible virtual currency to pay for goods or services in a real-world economy transaction, has tax consequences that may result in a tax liability”. No inference should be drawn with respect to virtual currencies not as described above.
There Is Capital Loss Or Gain When Disposing Virtual Currencies
As a consequence of bitcoin’s classification as “property,” every exchange of bitcoin is a taxable transaction. This includes exchanges of bitcoin for cash, for goods/services, and even for other altcoins.
Here are some more factors to be considered on the exchange of bitcoin:
Cost basis is the original value of an asset for tax purposes, and is usually equal to the purchase price of the property given up in a transaction. The preferred system by the IRS is to assume that the bitcoins are sold in the order they were acquired.
Thus, the first bitcoin purchased is assumed to be first bitcoin sold. It is irrelevant whether or not the transaction involved fiat. If an exchange occurred, and as a result of that exchange the taxpayer gave up bitcoin and received something other than bitcoin in return, then a taxable transaction has occurred.
In the case of a sale, amount realized is equal to sales price, reduced by any selling costs incurred in the transaction. In the case of an exchange of bitcoins for goods or services, then amount realized is the value of the goods or services received in the exchange. In most cases, this would be the price of the goods/services as denominated in fiat currency.
Since the Bitcoin is regarded as an asset, reporting capital gains from the sale/exchange of bitcoin is the same as other types of capital assets. So, net short-term and long-term capital gains are reported on Schedule D of Form 1040.
The individual transactions themselves are reported on Form 8949. If there is a high volume of transactions, they can be reported on a separate statement and attached to Form 8949 instead. Note that each and every individual transaction must be reported on Form 8949 or an attached statement.
Profits are calculated by taking the amount realized in each transaction and subtracting the cost basis of the bitcoins given up. If the amount realized was greater than the cost basis, there is a gain, else the amount realized is lesser, then there is a loss.
Then, you determine the net gain or loss for the year. Therefore, taxpayers must calculate the amount of their gain or loss on every single transaction involving bitcoin.
An Effective Record Keeping System For Transactions Must Be Established
It is highly advisable for everyone involved in the use of virtual currencies to have a good record keeping system. Keeping detailed records of transactions in virtual currency ensures that income is measured accurately.
The records kept might include the same information that appears on a stock or forex brokerage statement: “Date of trade, Description of trade, Qty & Price, and Fees”.
Depending on how the revenue is to be treated, you may need to know when the Bitcoin proceeds were attained.
Regardless of how revenue is recognized for goods and services whose payment is made using Bitcoins, the recordkeeping requirements are likely to be the same: Reference to sales (e.g., cost # / invoice #), amount received (in BTCs) and date. If sales taxes are payable, then for that purpose documentation might include a calculated based on a weighted average exchange rate that existed at the time of sale.
Employers sending bitcoins as compensation would likely record all calculations in the fiat currency (e.g., USDs) and then after all withholding amounts are subtracted the net amount of the check is paid out in bitcoins based on the market exchange rate at the time.
Bitcoin Miners Must Report Receipt of the Virtual Currency as Income
When a taxpayer successfully “mines” virtual currency, the fair market value of the virtual currency as of the date of receipt is includible in gross income. According to the IRS, when a taxpayer successfully “mines” Bitcoins and has earnings from that activity whether in the form of Bitcoins or any other form, he or she must include it in his gross income after determining the fair market dollar value of the virtual currency as of the day he received it.
If a taxpayer’s “mining” of virtual currency constitutes a trade or business, and the “mining” activity is not undertaken by the taxpayer as an employee, the net earnings from self-employment resulting from those activities constitute self-employment income and are subject to the self-employment tax.
That is, If a bitcoin miner is self-employed, his or her gross earnings minus allowable tax deductions are also subject to the self-employment tax.
General Tax Tips For Individuals and Organization Involved in Bitcoin and Other Virtual Currencies
- Establish a record-keeping system.
- Identify your cost basis method and the exchange rate.
- Keep track of when you acquire and when you dispose of bitcoins.
- Each purchase using bitcoin is two transactions in one: an implied disposition and an expense.
- Identify an exchange rate to use consistently in valuing bitcoins received.
- Taxes are paid in dollars, not in bitcoin. Consider converting bitcoins to dollars on a regular schedule so that you have enough dollars to remit any income tax, withholding, or sales tax.
- Sales revenue and expenses are also recorded in dollars.
- Keep separate wallets for short-term trading, long-term buy-and-hold positions, and personal spending.
- Gain or loss on holding bitcoin are recorded as trading gains
- Always include bitcoin transactions when figuring your estimated tax payments.
- Merchants should charge sales tax when a customer buys from you using bitcoin, if that's required in your line of business.
- When paying an independent contractor $600 and above during the year, request Form W-9 and issue Form 1099-MISC, even if you pay them in bitcoin. Track the amount paid to contractors throughout the year to measure whether you reach the $600 threshold. Backup withholding may be required.
- Miners should identity the tax treatment for bitcoins received by mining.
- It is important for investors to Watch the tax rates: gains subject to the 3.8% net investment income tax.
- Employers paying employees in bitcoin, first withhold all applicable payroll taxes in US dollars. Net pay can then be paid out in bitcoin as appropriate.
- For investors, normal capital gains strategies apply: offset gains with losses, time dispositions to qualify for long-term treatment, harvesting losses, and harvesting gains.
Tools For Calculating Bitcoin Tax
Following all the specifications by the IRS may be cumbersome for some individuals. Fortunately, there are quite a few tools available which will help users take care of these problems with relative ease. Some of these tools will be discussed below:
LibraTax is known to be one of the oldest bitcoin taxation solutions tools ever created.
LibraTax has been around for quite some time and remains one of the most commonly used platforms for bitcoin taxation calculations. The company has a thorough FAQ on their website explaining the bitcoin taxation process as a whole.
Interestingly enough, LibraTax for individuals is free of charge, but there is a paid plan for users who prefer to receive an option report. Upon choosing a reporting method, an additional feature becomes available – automatic generation and completion of IRS Form 8949 that needs to be included on all tax returns with bitcoin activity.
LibraTax can automatically import transactions from Blockchain and exchanges. Currently LibraTax is only useful for people who live in the United States.
CoinTracking tracks user’s coin history and determine how much tax needs to be paid as a result. With a wide range of supported cryptocurrencies – including bitcoin, Ethereum, Ripple, and thousands of others – filling in those tax forms becomes very straightforward.
Moreover, this platform is specialized doing extracting trading information from individual exchanges, which makes it quite attractive. The platform also supports 25 different exchanges which allows users to import their data from their preferred exchanges.
Users also receive interactive charts for all their currencies and trades, as well as an overview of potentially unrealized gains.
Bitcoin Taxes also claims to offer this solution free of charge, which makes it quite a powerful tool to help during the tax season. Some of the Bitcoin Taxes features include support for major world currencies, importing mining income, and importing trade histories from multiple exchanges. Additionally, the company also provides tax professional and accountant packages for users looking for more advanced bitcoin tax solutions.
Bitcoin Taxes’ objective is to help users calculate capital gains and losses for bitcoin. Since most people aren’t aware of the cost-bases of every BTC they own or how much profit they made exactly, it is very important to have access to the right data.
On Bitcoin Taxes, Capital gains are calculated in the user's fiat currency using First-In-First-Out (FIFO) and a number of other cost-basis methods, such as Last-In-first-Out, Closest-Price-First-Out and average costing.
Kryptofolio+tax is a free mobile app available on major mobile operating systems with a fully configurable first in first out-portfolio manager and additionally tax calculator for bitcoin. It works by setting up percentage cuts of capital gain, sales and flat values on specific transaction types.
It can be configured use in almost any jurisdiction as a supplement to current tax arrangements. It can also import transactions either from blockchain.info or via a csv file import direct from a wallet export for all crypto-currencies.
For maximum privacy, transactions can be converted to QR codes to be scanned directly into the device without being broadcast.
BitPrices is an open-source command-line tool with a companion website mybitprices.info intended for viewing fiat value of transactions on the day they occurred. It is useful for auditing wallet transactions and determining cost basis.
The website is free to use and does not require any registration or login. The tool can generate highly customizable transaction reports as well as a schedule D report with realized gains. FIFO and LIFO cost-basis methods are supported. This tool requires a list of all Bitcoin addresses in your wallet including change addresses.