Bitcoin is a virtual currency that uses a cryptographic encryption system to facilitate secure transfers and storage. Unlike a fiat currency, bitcoin is not printed by a central bank, nor is it backed by any. Bitcoins are generated by what is called mining—a process wherein high-powered computers, on a distributed network, use an open-source mathematical formula to produce bitcoins.

It takes real high-tech hardware and hours or even days to mine bitcoins. One can either mine bitcoins or buy them from someone by paying cash, using a credit card, or even a PayPal account. Bitcoins can be used like fiat world currency to buy goods and services.

Key Takeaways

  • Bitcoin is a decentralized cryptocurrency used like fiat currency to buy and services.
  • In the U.S., the IRS considers bitcoins as assets, rather than currency.
  • U.S. taxpayers must report bitcoin transactions for tax purposes.
  • If bitcoins are held for less than one year before the transaction, short-term capital gains are applied.
  • If bitcoins are held for more than one year before the transaction, long-term capital gains are applied.

Understanding Bitcoins

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.

At the start, bitcoin's attractiveness was attributed partly to the fact that it wasn't regulated and could be used in transactions to avoid tax obligations. The virtual nature of bitcoin and its universality also make it harder to keep track of in cross-country transactions.

Also, government authorities around the world soon realized that bitcoin attracted black marketers who could make illegal deals. Naturally, bitcoin couldn't escape the tax authorities' radars for long.

Bitcoins & Taxation

Around the world, tax authorities have tried to bring forth regulations on bitcoins. The U.S. Internal Revenue Service (IRS) and its counterparts from other countries are mostly on the same page when it comes to the treatment of bitcoins.

The IRS has said that the bitcoin should be treated as an asset or an intangible property and not a currency as it is not issued by a central bank. Bitcoin's treatment as an asset makes the tax implication clear.

The federal agency said in July 2019 that it was sending warning letters to more than 10,000 taxpayers it suspects "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 can result in penalties, interest, or even criminal prosecution.

The IRS has made it mandatory to report bitcoin transactions of all kinds, no matter how small in value. Thus, every U.S. taxpayer is required to keep a record of all buying, selling of, investing in, or using bitcoins to pay for goods or services (which the IRS considers bartering).

Because bitcoins are currently being treated as assets, if you use bitcoins for simple transactions, such as buying groceries at a supermarket, you will incur a capital gains tax (either long-term or short-term depending on how long you held the bitcoins). When it comes to bitcoins, the following are different transactions that will lead to taxes:

  • Selling bitcoins, mined personally, to a third party
  • Selling bitcoins, bought from someone, to a third party
  • Using bitcoins, which one may have mined, to buy goods or services
  • Using bitcoins, bought from someone, to buy goods or services

Scenarios one and three entail mining bitcoins, using personal resources, and selling them to someone for cash or equivalent value in goods and services. The value received from giving up the bitcoins is taxed as personal or business income after deducting any expenses incurred in the process of mining.

Such expenses may include the cost of electricity or the computer hardware used in the mining of bitcoins. Thus, if able to mine 10 bitcoins and sell them for $250 each, you have to report the $2,500 as taxable income before any deductible expenses.

Scenarios two and four are more like investments in an asset. Let’s say bitcoins were bought for $200 each, and one bitcoin was given up in exchange for $300 or an equivalent value in goods. The investor has gained $100 on one bitcoin over the holding period and will attract capital gains tax (long-term if held for more than one year) on the excess.

Short-Term and Long-Term Capital Gains

If bitcoins are held for less than a year before selling or exchanging, a short-term capital gains tax is applied, which is equal to the ordinary income tax rate for the individual. However, if the bitcoins were held for more than a year, long-term capital gains tax rates are applied.

In the U.S., long-term capital gains tax rates are 0% for people with taxable incomes less than $78,750, 15% for single tax filers with taxable incomes between $78,750 and $434,550 ($488,850 for married couples filing jointly and widow(er)s, $244,425 for married couples filing separately, and $461,700 for heads of household), and 20% for those with taxable incomes that exceed the 15% threshold.

Thus, individuals pay taxes at a rate lower than the ordinary income tax rate if they have held the bitcoins for more than a year. However, this also limits the tax deductions on long-term capital losses one can claim. Capital losses are limited to total capital gains made in the year plus up to $3,000 of ordinary income.

Special Considerations

Taxation on bitcoins and its reporting is not as simple as it seems. For starters, it is difficult to determine the fair value of the bitcoin on purchase and sale transactions. Bitcoins are very volatile and there are huge swings in prices on a single trading day.

The IRS encourages consistency in your reporting. If you use the day's high price for purchases, you should use the same for sales as well. Also, frequent traders and investors could use "first-in, first-out" (FIFO) or "last-in, first-out" (LIFO) accounting techniques to reduce tax obligations.