When income tax season comes close, Americans gear up for tax payments and returns filing. It is also the time to start the work for maintaining fresh records for the next financial year. Amid all the developments, participants who have dealt in cryptocurrencies like bitcoins are a worried lot.
In 2017, the Internal Revenue Service (IRS) ordered the Coinbase cryptocurrency exchange to hand over all the necessary data related to the transactions made by more than 14,000 of its customers who bought, sold, received, or sent more than $20,000 worth of bitcoins (BTC) between 2013 and 2015. Those who suspected then that Uncle Sam was prepared to scrutinize and levy the necessary taxes, and penalties, on bitcoin dealings, were correct. On July 26, 2019, the federal body said it will send educational letters to 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."
"Taxpayers should take these letters very seriously by reviewing their tax filings and when appropriate, amend past returns and pay back taxes, interest, and penalties," said IRS Commissioner Chuck Rettig in a press release. "The IRS is expanding our efforts involving virtual currency, including increased use of data analytics. We are focused on enforcing the law and helping taxpayers fully understand and meet their obligations."
Though these developments may have come as a surprise to some proponents of the cryptocurrency, it is important to realize that taxes are imminent, irrespective of the nature of dealings and the asset classes.
Let’s look at a few important pointers that will help in preparing tax returns for filers who bought or sold cryptocurrencies.
Bitcoin Record-Keeping Is Your Responsibility
There are hundreds of brokers, intermediaries, and exchanges that offer cryptocurrency trading. However, none are obligated to provide tax reports to market participants though a few may do so at their own discretion. For instance, Coinbase does provide a "cost basis for taxes" report.
In the end, the individual is responsible for maintaining the necessary records related to their cryptocurrency dealings.
Say, six months back you bought 10 bitcoins at the rate of $3,000 each or may have received them as a payment for work you did for a client. Today, those bitcoins may be worth $9,000 each, putting your potential profit at $6,000 per coin.
It is your responsibility to have the necessary records showing that you received them at the time when they were worth $3,000, and hence your net income is $6,000 per coin. Failing to maintain such transaction data and documents may lead to your holdings being assessed at today’s value of $9,000 each, significantly increasing your tax burden.
Any dealing in bitcoins may be subject to tax. Say, you received five bitcoins five years ago, and spent one at a coffee shop four years back, spent another two for buying goods at an online portal three years back, and sold the remaining two and got the equivalent dollar amount one month back. For each such transaction on the various dates, you are expected to maintain the dollar equivalent value for each and compute your net dollar income from bitcoins. Your tax liability will be computed accordingly.
Understanding Bitcoin Taxation
To maintain records correctly, it is important to understand how various dealings of cryptocoins are taxed. Depending upon the kind of bitcoin dealing, here are the various scenarios that should be kept in mind for tax preparations:
If bitcoins are received as payment for providing any goods or services, the holding period does not matter. They are taxed and should be reported, as ordinary income using the fair market value on the date of the transaction. Federal tax on such income may range from a 10% to 37% marginal tax rate. Additionally, there may be state income taxes to be paid.
If bitcoins are received from mining activity, it is treated as ordinary income. Additionally, there may be a self-employment tax to be paid on such receipts.
If cryptocoins are received from a hard fork exercise they are not treated as ordinary income, but through other activities like an airdrop, they are treated as ordinary income.
If bitcoins are bought as an investment and sold at a profit, the treatment of such income depends on the holding period. If held for less than a year, the net receipts are treated as ordinary income which may be subject to additional state income tax. If the holding period is for more than a year, it is treated as capital gains and may attract an additional 3.8% tax on net investment income.
Account for Bitcoin Tax Reductions
If you’ve donated your cryptocoins, like bitcoin or ethereum, to eligible charities, then you may qualify for reduced tax liability.
For instance, in 2017 the Fidelity Charitable fund received bitcoin donations worth around $69 million. The working mechanism of the charitable fund ensures that the received bitcoins are immediately sold on the Coinbase exchange. The dollar amount received from such a sale is invested as per the choice of the donor, who benefits by receiving a tax deduction in the year of the donation.
However, care should be taken that only cryptocoin donations made to eligible charities qualify for such deductions. Selling the tokens and then donating the dollar amount will not reduce your bitcoin tax burden. Additionally, the deductions are available for individuals who itemize their tax returns.
Provisions for Cryptocurrency Losses
Similar to tax rules for stock investments, cryptocurrency losses can be used to offset capital gains, subject to certain rules, and losses that are not used to offset gains can be deducted—up to $3,000—from other kinds of income. The rules also have provisions for carry-forwarding losses.
Reporting Bitcoin Income
Income from bitcoin dealings should be reported in Schedule D, which is an attachment of form 1040. Depending upon the type of dealing which decides the type of income from cryptocurrency—ordinary income or capital gain—the income should be reported under the correct head in the appropriate columns of the form.
The Bottom Line
While the IRS released its first set of guidelines and rules in 2014, fewer than 900 individuals reported capital gains or losses related to Bitcoin trading between 2013 and 2015. As the IRS starts to crack down on cryptocurrency taxation, it is important for individuals to maintain records of their dealings, and remain prepared for any scrutiny, tax payments, and any possible penalties.
Investing in cryptocurrencies and other Initial Coin Offerings ("ICOs") is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or other ICOs. Since each individual's situation is unique, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein.