More than a decade after Bitcoin’s introduction, there is still considerable confusion about its taxes. The cryptocurrency was conceived of as a medium for daily transactions but it has yet to gain traction as a currency. Meanwhile, it has become popular with speculators and traders interested in making a quick buck off its volatility.
The Internal Revenue Service addressed cryptocurrency transactions in its notice 2014-21. The agency stated that cryptocurrencies would be treated as an asset similar to property. In 2019, the IRS began including a question on its Form 1040 to determine whether the tax payer had any cryptocurrency transactions during the given tax year.
Depending on the type of transaction, assets are subject to various kinds of taxes. But the unique characteristics and use cases for Bitcoin means that there are several exceptions.
- Bitcoin has been classified as an asset similar to property by the IRS and is taxed as such.
- U.S. taxpayers must report Bitcoin transactions for tax purposes.
- Retail transactions using Bitcoin, such as purchase or sale of goods, incur capital gains tax.
- Bitcoin mining businesses are subject to capital gains tax and can make business deductions for their equipment.
- Bitcoin hard forks and airdrops are taxed at ordinary income tax rates.
- Gifting, donating, or inheriting Bitcoins are subject to the same limits as cash or property transactions.
Bitcoins & Taxation Frequently Asked Questions
Bitcoin is now listed on exchanges and has been paired with leading world currencies, such as the U.S. dollar and the euro. The U.S. Treasury acknowledged the growing importance of bitcoin when it announced that bitcoin-related transactions and investments cannot be deemed illegal.
Here are some answers to important questions about taxes associated with Bitcoin.
Do you have to pay taxes on Bitcoin transactions?
The short answer to that question is yes. Bitcoin’s classification as an asset makes its tax implications clear. The IRS has made it mandatory for taxpayers to report bitcoin transactions of all kinds, no matter how small in value. Every U.S. taxpayer is required to keep a record of all buying, selling, investing or usage associated with their Bitcoin. The IRS sent warning letters in July 2019 to more than 10,000 taxpayers it suspected “potentially failed to report income and pay the resulting tax from virtual currency transactions or did not report their transactions properly.” It warned that incorrect reporting of income could result in penalties, interest, or even criminal prosecution. .
Which types of Bitcoin transactions are taxed?
The following types of transactions using Bitcoin are considered taxable:
- Sale of Bitcoins, mined personally, to a third party.
For example, if you mine a Bitcoin and sell it to another party for a profit, then you have to pay capital gains taxes on the transaction.
- Sale of Bitcoins, bought from someone, to a third party.
For example, if you purchase Bitcoin at a cryptocurrency exchange or from another person and sell it for a profit, then you have to pay capital gains taxes on the transaction.
- Using mined Bitcoins to buy goods or services.
For example, if you purchase coffee using Bitcoin that you mined at home, then you have to pay taxes on the transaction. (The amount of taxes depends on the specifics of the transaction, such as the value of Bitcoin at the time of sale and the price of coffee).
- Using Bitcoin, bought from someone, to buy goods and services
For example, if you withdraw Bitcoin from an exchange to your personal wallet and make a goods purchase with it, then you are liable for capital gains taxes.
The first and third scenarios are taxed as personal or business income after deduction of expenses incurred during the process of mining. The second and fourth scenarios are more like investments in an asset.
Let’s say you purchased a Bitcoin for $200 and sold it for $300 or used an equivalent value in goods. You are liable to pay capital gains tax on the $100 profit from the transaction.
Do I have to pay taxes if I receive cryptocurrencies as payment for goods and services?
Salaries or payments received in cryptocurrencies are treated as ordinary income for tax purposes. The value or cost basis for the cryptocurrency is its price on the day at which it was used for salary payment.
Do I have to pay taxes if I am a Bitcoin miner?
Yes. Cryptocurrency mining is considered a taxable event. The fair market value or cost basis of the coin is its price at the time at which you mined it. The good news is that you can make business deductions for equipment and resources used in mining. The nature of those deductions differs based on whether you mined the cryptocurrencies for personal or individual gain. If you run a mining business, then you can make the deductions to cut down your tax bill. But you cannot make these deductions if you mined the cryptocurrencies for personal benefit.
Do I have to pay taxes when I convert from one cryptocurrency to another?
Some have argued that conversion of one cryptocurrency to another, say from Bitcoin to Ether, should be classified as a like-kind transfer under Section 1031 of the Internal Revenue Code. The IRS allows you to defer income tax on such transactions. Many crypto investors took advantage of this provision to defer their income from crypto trades during the early days of crypto trading. However, in a Memorandum from the Office of Chief Counsel released on June 18, 2021, the IRS ruled that such exchanges do not qualify as a like-kind exchange under Section 1031. What's more, the Tax Cuts and Jobs Act (TCJA) of 2017 put an end to that practice by clarifying that like-kind transfers are restricted to property transactions.
What are the tax implications when a blockchain undergoes a hard fork or cryptocurrencies are dropped?
Hard forks of a cryptocurrency occur when a blockchain split occurs, meaning there is a change in protocols. A new coin, with differences in mining and use cases from its predecessor, is created. Holders of the original cryptocurrency may be given new coins. This practice is also known as an airdrop and is also used as a marketing tactic by developers of new coins to induce demand and usage.
Previously, there were several questions swirling around the tax implications of hard forks and airdrops. For example, should they be treated as stock splits or dividends? Is an airdrop free income?
In a 2019 ruling, the IRS clarified that hard forks do not result in gross income, if the wallet holder does not receive units of cryptocurrency. Airdrops, on the other hand, qualify as gross income after the holder receives units of a new cryptocurrency either after a hard fork or by marketers of a coin. In the latter case, the quantity and time at which a crypto wallet holder receives the new coins determines the tax amount. Airdrops are taxed as ordinary income.
What are the tax implications of donating, gifting, or inheriting cryptocurrencies?
Cryptocurrency donations are treated in a similar fashion as cash donations. They are tax-deductible. An appraiser will assign a fair market value for the coin based on its market price at that time. The donor is not required to pay any taxes on the price gain. Gifts of cryptocurrency below $15,000 are not subject to income. If the recipient of a crypto gift over $15,000 decides to sell the gift, then their cost basis remains the same as that of the donor. Inherited crypto assets are treated the same way as other assets, meaning they are subject to the same estate regulations as other assets.
What are some special considerations for cryptocurrency taxes?
Taxation of Bitcoin and its reporting is not as simple as it seems. For starters, the volatility of bitcoin price makes it difficult to determine fair value of the cryptocurrency on purchase and sale transactions. It is also difficult to use identify the appropriate accounting method for use in cryptocurrency taxation. Last In, First Out (LIFO) and Highest In, First Out (HIFO) have the potential to decrease taxes but the IRS has approved very few instances of their use for crypto traders. First In, First Out is the most commonly-used method for cryptocurrency accounting.