It’s fascinating how the exploding rise of Bitcoin’s value has shaken the ground of digitally skeptical investors. Everyone wants a piece of it now! In the meantime, a great part of those who have already invested in Bitcoin is looking for a way to cash out and profit from the unexpected price boom.
Apparently, the massive Bitcoin rush keeps us so busy that we neglect a critical moment concerning digital assets – taxation. Above all else, don’t let Bitcoin attributes like “unregulated”, “anonymous”, and “decentralized” lead you to the conclusion that crypto profits are “tax-free”. Even though Bitcoin and other available altcoins are handled outside centralized financial systems, it doesn’t exempt you from tax liability. What tax is applied then? We’ll see. But let’s discuss things step by step.
This article will focus on the main regulative points and provide you with a compact guide on how the IRS categorizes your Bitcoin purchases and sales with an important reference to Cryptocurrency IRAs. So, let’s do the math!
How Does the IRS Tax Bitcoin?
Bitcoin and other blockchain-based currencies are frequently referred to as convertible virtual currencies if either they have established value against other regular currencies or if they function as regular currencies themselves. They can be virtually traded and exchanged into both fiat currencies and cryptocurrencies. However, Bitcoin and other altcoins are not considered legal tender in any legal system.
In 2014, the IRS issued an official notice according to which all “convertible virtual currencies” must be treated as property, not a legal currency, and therefore are subject to capital gains taxes. This means there will be further taxations in case Bitcoin is purchased, sold, or exchanged.
This is the initial distinction that defines how altcoins are taxed, the approach you should take towards correct calculation, and your tax-planning strategies.
Since the US tax law classifies Bitcoin and other cryptocurrencies as subject to capital gains taxes, you will pay taxes when the gains are materialized. Similarly, to trading stocks, you are obliged to list the gains you’ve received from Bitcoin as income only when you choose to sell them. In simpler terms, the fact that your Binance portfolio grew immensely in volume in 2020 doesn’t mean you need to pay any applicable gains tax yet.
Over the past decade, Bitcoin has slowly evolved and has now become a sensible long-term investment. It now resembles gold thanks to two things: the limited reserves and its bright economic value estimation. Therefore, most investors see an incredible opportunity to store Bitcoin in their digital wallets as, by any interpretation of the law, it allows long-term asset growth separated from federal income tax.
The IRS Notice 2014-21 clearly states that any gains and losses obtained from the sale of Bitcoin are subject to capital gains tax. There is no room for further negotiations – any gain is income, and any income is taxable regardless of the currency you are paid in.
In order to determine the amount of capital gain from a transaction that includes Bitcoin, we need to apply two tax principles: basis and holding period. The basis is simply the price you paid for the asset. In terms of cryptocurrency, if you bought your Bitcoin back in December 2017, the basis for your coin is $20,000.
The holding period determines the tax rate you will pay for the transaction of capital gain to a great extent. Thus, if you’ve held your Bitcoin for less than 12 months, the regular income tax rate will be applied. However, there is a long-term tax for traders who have kept their BTC for longer than a year. For a single trader with earnings of up to $40,000 per year, the capital gains tax is 0%. Bitcoin traders with income between $40,000 and $441,450 will have to pay 15%, while 20% is calculated for those whose earnings exceed the latter sum.
There are a couple of Bitcoin transactions that are not considered a direct taxable event. For example, if you receive Bitcoin as a present or donate some to charity. However, once you decide to spend or sell your Bitcoin gift, taxes need to be applied accordingly. Just note that the gains from Bitcoin mining are not excluded from taxation.
Finally, your losses can be used to lower your general taxable income by a maximum of $3,000 ($1,500 for a married couple listing the losses separately).
Paying Goods and Services with Bitcoin
The IRS doesn’t differentiate between selling Bitcoin or using it as a payment method as long as its value on the transaction date (referred to as fair value), is considerably higher than the basis.
Let’s illustrate this with an example. You’ve read that Elon Musk is offering people to buy Tesla cars with Bitcoin. So, if you bought Bitcoin for $230 out of curiosity back in September 2015, in 2021, you could afford a decent Tesla model! Since at the beginning of 2021 the price of Bitcoin was around $60,000, you had actually made a gain of nearly $120,000, and according to the IRS, you have to pay 15% of the total transaction provided you earn more than $40,000.
Can I Avoid Capital Gains Tax?
The answer is no. Starting from 2020, the tax 1040 form addresses a specific question on the front page asking the preparer whether they received, sold, sent, exchanged, or otherwise acquired any financial interest in any virtual currency at any time during 2020.
It’s an open secret that taxpayers massively ignored this income source for a long time. But there are no “innocent” excuses one can make any more if they want to underreport their capital gains resulting from crypto trading.
Investing in Bitcoin in a Cryptocurrency IRA
Since Bitcoin is considered a property, you can invest in Bitcoin with a retirement account such as a Traditional IRA. You can choose between Bitcoin and other cryptocurrencies supported by IRA custodians such as Bitcoin Cash (BCH), Ethereum(ETH), Ethereum Classic (ETC), Stellar(XLM), Litecoin(LTC), and Zcash (ZEC).
Since cryptocurrencies are treated as property, an IRA may be used to invest in Bitcoin. This investment method gained wide public attention because it relieves the taxation burden as long as the assets are held within your IRA account. If your IRA invests in Bitcoin, it is processed the same as any other investment asset, and it is not subject to capital gains tax. However, if you hold your crypto in a Traditional Cryptocurrency IRA (pre-income tax funds), any distribution will result in 1099 from your custodian and will be taxed as income.
The world’s economy is rapidly transitioning towards digital assets. Rocky shifts in the business ecosystem over the years have demonstrated their power, and there is no stepping back. Blockchain technology has already settled as the “new normal”. Prepared or not, cryptocurrencies are the future of finance.
If you still feel reluctant about digital investments, contact our outstanding Coin IRA team of crypto specialists – they know the way and will gladly educate you. With their substantial experience, you will learn that the process of investing in your future has never been easier.