Many military investors have jumped into Bitcoin and other cryptocurrencies. As these assets have skyrocketed in value, some people have experienced tremendous gains. But, these gains also come with a cost – taxes. As such, we’ll use this article to explain how taxes on cryptocurrencies like Bitcoin work.
Specifically, we’ll discuss the following:
- How the IRS Treats Cryptocurrencies like Bitcoin
- Determining Cryptocurrency Cost Basis
- Cryptocurrency Sales: Short- vs. Long-term Capital Gains
- Ordinary Income Tax Situations with Cryptocurrency
- Final Thoughts
How the IRS Treats Cryptocurrencies like Bitcoin
When cryptocurrencies like Bitcoin came into existence, the IRS didn’t have a clear policy on taxing these assets. This is no longer the case. Currently, the IRS requires that you report nearly all crypto-related transactions when you file your annual tax return. More precisely, at the top of your IRS Form 1040, taxpayers must now answer the following question: At any time during 20XX, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?
NOTE: The IRS explicitly states: If your only transactions involving virtual currency during 20XX were purchases of virtual currency with real currency, you are not required to answer yes to the Form 1040 question.
After reporting cryptocurrency transactions, the question becomes, how does the IRS tax them? According to the IRS, cryptocurrency: […] Is a type of virtual currency that uses cryptography to secure transactions that are digitally recorded on a distributed ledger, such as a blockchain. However, the term virtual currency is somewhat misleading, as the IRS doesn’t consider cryptocurrency an actual currency like US dollars. Rather, it: […] Is treated as property and general tax principles applicable to property transactions apply to transactions using virtual currency.
Put simply, the IRS considers cryptocurrency to be property – not currency. Accordingly, to understand how the IRS taxes Bitcoin sales, you need to first understand how the IRS taxes property sales, in general.
Determining Cryptocurrency Cost Basis
Taxes related to property sales depend on the tax concept of “cost basis.” In basic terms, cost basis equals a property’s original value. That is, how much did it cost you to purchase an item? For cryptocurrency purchases, that original value equals the amount you paid – in US dollars – for a certain amount of Bitcoin or other coin.
For example, say that you purchased two Bitcoin at $10,000/coin. Your cost basis for tax purposes would equal $20,000 (two Bitcoin x $10,000/coin). But, say that the exchange where you purchased this Bitcoin also charged a $50 transaction fee. While the IRS doesn’t let you directly deduct that cost, you can add it to your cost basis. This has the effect of eventually reducing your taxable gain at sale. In this example, that would mean that you have a cost basis of $20,050 when you add the transaction fee.
From this cost basis, the IRS determines your taxable gain when you sell an item. More precisely, when you sell property like cryptocurrency for more than your cost basis, you recognize a capital gain, which we’ll discuss in the next section.
NOTE: Many cryptocurrency exchanges will calculate your cost basis automatically. Some exchanges will even provide you an IRS Form 1099 on an annual basis (the type of 1099 will depend on the associated activity for the tax year). If not, you or your tax advisor should maintain detailed records of the amounts, dates, and fees for all cryptocurrency purchases and sales.
Cryptocurrency Sales: Short- vs. Long-term Capital Gains
While capital gains become more complicated when selling real estate investments, cryptocurrency calculations are fairly straightforward. To calculate capital gains from a cryptocurrency sale, subtract your cost basis and any sale-related transaction fees from the sale price:
Capital Gain = Sale Price – Transaction Fees at Time of Sale – Cost Basis
Continuing the above example, assume that you sold those same two coins when Bitcoin prices had increased to $30,000/coin. Your sale price would then equal $60,000 (two Bitcoin x $30,000/coin). And, say that the exchange also charged another $50 transaction fee. In this situation, your capital gains on the cryptocurrency sale would be as follows:
Capital Gain = $60,000 Sale Price – $50 Transaction Fee at Sale – $20,050 Cost Basis
Capital Gain = $39,900
At this point, you know that you have $39,900 in taxable capital gain. Next, you need to figure out the rate at which the IRS will tax that gain. This depends on the length of time that you held the Bitcoin before selling it.
If you held it for a year or less, the IRS considers your gain a short-term capital gain. And, the IRS taxes these gains at your ordinary income tax rate (i.e. your marginal tax rate). Currently, these rates range from a low of 10% to a high of 37%. If you held these two Bitcoin for six months prior to sale and fall in the 24% income bracket, your capital gain tax would equal:
Capital Gain Tax = $39,900 Short-term Capital Gain x 24% Tax Bracket
Capital Gain Tax = $9,576
On the other hand, if you held the Bitcoin for more than a year before selling it, the IRS considers the gain a long-term capital gain. To incentivize long-term investments, the IRS uses lower, long-term capital gain tax rates of 0%, 15%, or 20%, depending on your income level. Assume you held your Bitcoin for two years and qualify for the 15% long-term capital gain rate. Your capital gain tax would equal:
Capital Gain Tax = $39,900 Long-term Capital Gain x 15% Tax Bracket
Capital Gain Tax = $5,985
As this basic example outlines, you would save $3,591 ($9,576 – $5,985) in taxes by holding your Bitcoin for more than a year. And, while real-world numbers vary, here’s the important takeaway: if you sell cryptocurrency at a gain after holding it for a year or less, you will pay more in taxes.
NOTE: Some high-income individuals also need to pay a 3.8% net investment income tax on top of the capital gains taxes. This tax is beyond the scope of this article, so consult with a tax professional if you believe you may fall into this category.
Ordinary Income Tax Situations with Cryptocurrency
When paying crypto-related taxes, most investors will deal with the above capital gains scenarios. But, in some situations, receipt of cryptocurrencies will qualify as ordinary income. For example, if you are either an A) employee, or B) independent contractor who receives Bitcoin (or any cryptocurrency) as payment for your services, that qualifies as ordinary income. This means that you need to pay A) ordinary income tax rates (10% to 37%), and B) payroll (or self-employment tax) on those earnings. More precisely, according to the IRS:
[…] The fair market value of virtual currency paid as wages, measured in U.S. dollars at the date of receipt, is subject to Federal income tax withholding, Federal Insurance Contributions Act (FICA) tax, and Federal Unemployment Tax Act (FUTA) tax and must be reported on Form W-2, Wage and Tax Statement.
For Independent Contractors
[…] The fair market value of virtual currency received for services performed as an independent contractor, measured in U.S. dollars as of the date of receipt, constitutes self-employment income and is subject to the self-employment tax.
This reality can pose major challenges to employers, employees, and independent contractors. Administratively, it’s difficult to track the fair market value of a cryptocurrency at the time of every payment. Additionally, the IRS does not accept Bitcoin or other cryptocurrencies to pay tax bills. As a result, when you make your payroll or self-employment tax payment, you still need to use cash, regardless of the fact that the wages were paid in Bitcoin or something similar.
While Bitcoin and other cryptocurrencies may seem like attractive investments, the associated taxes can be significant. Before buying crypto or accepting it as payment for services, we highly recommend developing a tax planning strategy. It’s far better to know how taxes on cryptocurrencies work before receiving your first tax bill than getting hit with a nasty surprise!
Maurice “Chipp” Naylon spent nine years as an infantry officer in the Marine Corps. He is currently a licensed CPA specializing in real estate development and accounting.