Bitcoin is the grandfather of cryptocurrency and the first official application for blockchain technology. This makes it an inherently disruptive technology. Bitcoin is disrupting traditional ledger technologies just as blockchain technology has disrupted them. It has also made waves in the currency and fintech spaces by successfully sustaining an open-source, decentralized digital currency solution. Bitcoin doesn’t need banks or centralized institutions to be its backbone. Instead, a cryptographic encryption network acts as the mathematical authority needed to verify and organize transactions. Bitcoin miners assign their computers to solve pieces of an open source algorithm that helps organize and verify transactions. This mathematical authority pays miners in Bitcoin for their hard work.
Miners
Miners can then convert Bitcoin to fiat money, such as USD, or use them directly to purchase goods and services. The relationship between Bitcoin and the US government is interesting. It is easy to see why the US government would be concerned about mainstream acceptance of Bitcoin, given its volatility and superficial associations with the criminal. Over time, however, Bitcoin’s resilience both as a currency and network, as well the efficiency and cost-effectiveness blockchain payments have made it a compelling option. Officials have accepted a gradual but substantial induction of Bitcoin into traditional financial services.
First, cryptocurrency exchanges began to pair Bitcoin with fiat currencies such as the dollar. These platforms, such as Binance and Coinbase, are still popular today. Bitcoin futures contracts are another sign of Bitcoin’s increasing prominence in finance. They can be traded on major institutional exchanges such as the Chicago Mercantile Exchange or the Chicago Board Options Exchange. Given the acceptance of Bitcoin and its gradual inroads into established markets, it makes sense that Bitcoin is now subject to institutional pressures. Regulators who are watching the latest entry to their ecosystem have had their own influence on Bitcoin.
Recently, the Internal Revenue Service (IRS), stated that it is currently sending 10,000 educational letters to taxpayers who it suspects owe taxes on virtual currency transactions. It is possible that the federal agency has used customer data from cryptocurrency exchange Coinbase to create its recipient list. The IRS warned that those who fail to correctly report income could face penalties, interest, and even criminal prosecution.
Bitcoin and Taxes
Although initially anonymous, today’s lion’s share is transparent. In the past, governments have seen a rise in illegal market trading with Bitcoin. To avoid being criticized by regulators, exchanges have imposed anti-money laundering requirements for Bitcoin traders. Taxes have been the biggest change for Bitcoin traders. Although regulators, central bankers and federal judges have differing opinions about how to categorize Bitcoin (whether it is a currency, commodity, or currency), they all seem to agree that it should be taxed. Most major countries tax cryptocurrencies similarly, too. What does this mean for traders?
The Details
First, it is important to remember that nothing is final until it’s made law. Although there is always speculation about what might happen based upon what a financial regulator says, no one has the power to unilaterally change the tax code or redefine assets. This is why little has changed since 2014 when the IRS first addressed cryptocurrency. The IRS Notice 2014-21 in the United States defines virtual currencies as property. This means that any digital currency purchased is subject to taxation as a capital gain, regardless of how long it was held.
If you buy a cup coffee with Bitcoin that you bought when it was worth $1,000 you must also account the Bitcoin price at the time. If Bitcoin is trading at $1200 when you purchase the coffee, it means that you have purchased a dollar-denominated asset with another asset that is worth more dollars. Capital gains rules will apply to the Bitcoin you have spent on the coffee. Although cryptocurrency brokers are not required to issue 1099 forms for clients, traders are required to disclose all information to the IRS. Otherwise, they could face tax evasion penalties. These are taxable transactions
- Using cryptocurrency to exchange fiat money or “cashing out”.
- Paying for goods and services such as Bitcoin to buy a cup coffee
- Exchange one cryptocurrency for another
- Receiving forked or mined cryptocurrencies
The IRS
These are not taxable events as defined by the IRS:
- Buying cryptocurrency using fiat money
- Donating cryptocurrency for a tax-exempt charity or non-profit
- Gifting cryptocurrency to a third party
- Transferring cryptocurrency between wallets
How to determine what you owe. It can be difficult to determine how much profit you have made and how much tax you are liable for.
Crypto Cashing Out
To comply with tax rules, anyone cashing out cryptocurrency for fiat currency like dollars will need to know the base price of the Bitcoin being sold. If you buy Bitcoin at $6,000 and sell it at $8,000 three years later, you will pay a short term capital gains tax (equivalent one’s income tax). Long-term capital gains taxes are applied to trades that occurred over a period of two years. This is 0% for those with a income below 10%, 15% for those between 25 and 35%, and 20% for those who are in higher income brackets.
It is different to sell cryptocurrencies one has mined, rather than those they purchased previously with fiat. They are receiving dollars in return for mining inputs that can only been described as work (and this is true with the term “Proof of Work”), so the income from selling mined cryptocurrency is subject to tax. You can also deduct expenses related to their mining operation such as electricity and PC hardware.
Personal Purchases
It is also complicated to calculate the taxes involved in buying a cup coffee with cryptocurrency. It is necessary to know the price of Bitcoin used to purchase the coffee and then subtract it from the price of the coffee.
Tax code currently allows taxpayers to exempt up to $200 per transaction for foreign exchange rate gains if the gain was derived directly from a personal purchase such as a cup or coffee. This is called a “de minimis election”. However, there is no exemption for small transactions. This can lead to a complicated tax problem if you trade crypto and use it to purchase goods and services.
It becomes more difficult to determine which coins were used for the purchase of the coffee, their basis prices and the related gains. This is especially true if the buyer is trading coins often. It is important to keep all transactions for every digital currency and wallet.
This only applies to gains. For capital asset trades and for-profit transactions, declaring a loss and getting tax deduction are not applicable. If one purchases Bitcoin at $8,000 and then uses it for a pair of jeans, when Bitcoin is worth $6,000 they cannot declare this as a loss on their tax returns.
Exchanging Cryptocurrencies
Investors are also exposed to taxes when they exchange cryptocurrencies. If you buy Ethereum with Bitcoin, you are effectively selling it. You will need to report the difference between the price of Bitcoin and Ethereum’s purchase price, as well as the price of Ethereum at the time of its purchase, in order to later sell it.
Many exchanges offer free exports of trading data to crypto traders, which can be used by an accountant or a diligent enthusiast to calculate their tax burden. These data can be recorded and highlighted with blockchain solutions. TrustVerse, a platform that uses smart-contracts to manage wealth, organizes one’s digital assets and digital identity on the blockchain. This ensures that the asset owner is able to address their tax and estate obligations with immutable accuracy.
When filing cryptocurrency taxes for the first-time, it is a good idea to consult a certified accountant. Although it may seem daunting to manage a multi-year trading career it is necessary. It is becoming easier as CPAs, tax professionals, and others learn more about crypto assets. The IRS has published a guide to amending tax returns to include cryptocurrency. The smart traders are well ahead of their obligations and now they can focus on the next year’s cryptocurrency market without worrying about the uncertainty.