Bitcoin is “the grandfather” of cryptocurrency, as well as the first official application of blockchain technology. Given this, it is an inherently disruptive technology. Just as blockchain technology has disrupted traditional ledger technologies, Bitcoin has made waves in the fintech and currency spaces by successfully sustaining a decentralized, yet secure digital currency solution.
Bitcoin does not need centralized institutions—like banks—to be its backbone. Instead, a cryptographic encryption system acts as the mathematical authority required to organize and verify transactions. Bitcoin miners task their PCs with solving pieces of an open-source algorithm, which helps to organize and verify transactions. In return for their hard work, this mathematical authority compensates miners in Bitcoin in proportion to their efforts. https://9750d5f9db2843fbe2fce31b535581f7.safeframe.googlesyndication.com/safeframe/1-0-38/html/container.html
Miners can then exchange Bitcoin for fiat money like USD, or use them to buy goods and services directly.
Bitcoin and the US government have an interesting relationship. Between Bitcoin’s trademark volatility, and its superficial associations with the nefarious, not to mention the anxieties officials must have about ceding monetary control and fiscal policy to what is essentially an algorithm and those that verify the transactions (if it would ever come to that), it makes sense that the government would be uneasy about mainstream acceptance of the currency.
However, over time, Bitcoin’s resilience as a network and a currency, as well as the expediency and cost-effectiveness of blockchain payments have made a case for the cryptocurrency that has proved quite effective. Accordingly, officials have tolerated a gradual yet substantial induction of Bitcoin into conventional financial services.
First, cryptocurrency exchanges started pairing Bitcoin to fiat counter-currencies such as the dollar. These platforms, like Binance and even Coinbase remain popular today. The increasing presence of Bitcoin in finance is also evidenced in Bitcoin futures contracts, which are traded on major institutional exchanges like the Chicago Mercantile Exchange and the Chicago Board Options Exchange.
Given this acceptance, and Bitcoin’s gradual inroads into the established market, it only makes sense that Bitcoin has become subject to some institutional pressures. And indeed, regulators watching over this latest entry to their ecosystem have also exerted their own influence on Bitcoin.
The Internal Revenue Service (IRS) recently said it is in the process of mailing 10,000 educational letters to taxpayers it suspects owe the government taxes on virtual currency transactions. It is entirely possible that the federal agency has based its list of recipients on customer data it acquired from cryptocurrency exchange Coinbase. Those who do not report income correctly can face penalties, interest or even criminal prosecution, warned the IRS.
Bitcoin and Taxes
While originally proclaimed anonymous, the lion’s share of Bitcoin transactions today are transparent. Governments have observed surges of black-market trading using Bitcoin in the past. Exchanges now impose anti-money laundering requirements on Bitcoin traders to avoid drawing the ire of regulators.
The biggest change for Bitcoin traders, though, has been taxes.
While regulators, central bankers, and federal judges all have different opinions on how to categorize Bitcoin, whether a currency or commodity, they all seem to agree it should be taxed. Most major countries tax cryptocurrencies similarly, too.
So, what does that mean for traders?
The first thing to know is that nothing matters until it’s put into law. There’s always speculation about what will happen based on what some financial regulator says, but no individual has the ability to redefine an asset or unilaterally alter tax code, and little has changed since the IRS first addressed cryptocurrencies in 2014.
In the United States, IRS Notice 2014-21 defines virtual currencies as property. This means anything purchased using a digital currency is liable to be taxed as a capital gain whether short or long term depending on how long the asset was held.
For instance, if you buy a cup of coffee using Bitcoin that you purchased when it was worth $1,000, you must also account for the price of Bitcoin at the time of the coffee purchase. If Bitcoin is trading at $1,200 when you buy the coffee, you’ve purchased a dollar-denominated good with another asset that is now worth more in dollars than it used to be. That means the amount of Bitcoin you spent on the coffee will be taxed according to capital gains rules.
While cryptocurrency brokers aren’t required to issue 1099 forms to clients, traders are supposed to disclose everything to the IRS or face tax evasion charges. Taxable transactions include:
- Exchanging cryptocurrency for fiat money, or “cashing out”
- Paying for goods or services, such as using Bitcoin to buy a cup of coffee
- Exchanging one cryptocurrency for another cryptocurrency
- Receiving mined or forked cryptocurrencies
The following are not taxable events according to the IRS:
- Buying cryptocurrency with fiat money
- Donating cryptocurrency to a tax-exempt non-profit or charity
- Making a gift of cryptocurrency to a third party
- Transferring cryptocurrency between wallets
How to Determine What You Owe
Determining how much profit you’ve made and how much you’re liable for in taxes is a bit complicated.
Cashing Out of Crypto
In keeping with standard tax rules, when cashing out cryptocurrency for fiat money like dollars, one will need to know the basis price of the Bitcoin they’re selling.
For example, if you bought Bitcoin at $6,000 and sold it at $8,000 three months later, you’ll pay a short-term capital gains tax (equivalent to one’s income tax) on the $2,000 gained. If the same trade took place over a two-year timeline, long-term capital gains taxes correspondneymar to one’s tax bracket are applied. This is 0% for those in the 10-15% income bracket, 15% for those in the 25-35% income bracket, and 20% for those in higher brackets.
Selling the cryptocurrencies that one has mined instead of those that they bought previously with fiat is a different story. Since they’re receiving dollars in exchange for mining inputs that can only be described as work (and indeed is so with the term “Proof of Work”), the profit made from selling mined cryptocurrencies is taxed as business income. One is also able to deduct the expenses that went into their mining operation, such as PC hardware and electricity.
The taxes on buying a cup of coffee with cryptocurrency are also convoluted. One must know the basis price of the Bitcoin they used to buy the coffee, then subtract it by the cost of the coffee.
Currently, tax code allows taxpayers to exclude up to $200 per transaction for foreign currency exchange rate gain, if the gain was derived from a personal purchase, like a cup of coffee. This is known as a de minimis election. But there is no “de minimis” clause that exempts small transactions, which can create a very tangled tax problem if one is constantly trading crypto and also using it to buy goods and services.
Determining which coins were used to buy the coffee, their basis price and according gains, and then repeating this for every purchase only gets more complicated if the buyer is also trading coins frequently. It’s therefore vital to remember to keep all transaction information for each digital wallet and currency.
Another complication comes with the fact that this only works with gains. Declaring a loss and getting a tax deduction is relevant only for capital asset trades or for-profit transactions. If one buys Bitcoin at $8,000 and then uses it to purchase a pair of jeans when Bitcoin is worth $6,000, they can’t declare this a loss on their tax forms.
Exchanging cryptocurrencies exposes investors to taxes as well. You’re effectively selling Bitcoin if you buy Ethereum with it, so you’ll need to report the difference in Bitcoin’s price between when you bought it and when you spent it on Ethereum, plus make note of the price of Ethereum at its purchase time for when you sell it later.
Many exchanges help crypto traders keep all this information organized by offering free exports of all trading data, which an accountant (or a diligent enthusiast) can use to determine their tax burden. Blockchain solutions are also well-suited to record this data and highlight relevant points of tax interest. Platforms like TrustVerse have smart-contract based wealth management services that organize one’s digital identity and their assets on the blockchain, to ensure that tax and estate obligations are addressed with immutable accuracy according to the asset owner.
It is always recommended to go to a certified accountant when attempting to file cryptocurrency taxes for the first time. While it might seem daunting to tackle a multi-year trading career, it must be done, and it’s getting easier as CPAs and other tax professionals learn more about crypto assets. For now, the IRS is letting people become accustomed to the new way of doing things and has published a guide on amending old tax returns to include cryptocurrency. Savvy traders are already ahead of their obligations and are now focusing on the next year’s crypto market without this cloud of uncertainty over their heads.
By Joe Liebkind | Published Jul 29, 2019