Bitcoin Tax Tips
For many members of the bitcoin community, this year was the worst ever for doing their taxes. I’ve heard countless stories of people spending hours upon hours tracking down records of bitcoin trades, mining pool payouts, and miscellaneous transactions. Many also ended up unexpectedly owing thousands of dollars in tax, which forced them to sell coins at depressed prices in order to pay it.
Here are a few tips to make the next tax season go a little smoother.
Bitcoin Tax Tip #1: Keep clean records of your Bitcoin trades
Trying to reconstruct records at the end of the year is a nightmare (as most of you know). Here are two things you should start doing now in order to save time come next April. First, find a single bitcoin exchange you like, and stick with it. This goes for mining pools as well. Switching between exchanges and mining pools needlessly complicates your records and makes for a miserable existence come tax season when all of these transactions have to be reconciled. If you must use more than one exchange (for example, in order to trade small altcoins), limit how often you transfer bitcoins back and forth between them. Decide on how much you want to invest in various altcoins, make the bitcoin transfer, and leave them there. This not only makes calculating gain/loss at the end of the year easier, it is also a good practice for limiting your exposure.
Second, start keeping a log of your transactions. Even though most bitcoin exchanges and mining pools now provide downloadable transaction reports, they contain different amounts of information stored in wildly different formats. As a result, you probably spent hours this year untangling a mess of .csv files and merging them into one usable spreadsheet. Unless you’re some kind of excel nerd and enjoy that kind of labor, spending a couple minutes each day (or week, depending on how many transactions you have) will help you avoid it all together. Get into the habit of entering your buys, sells, conversions, and transfers right after they happen. You should keep track of the date, the sake or purchase price, and the quantity bought or sold in each transactions. You should also enter the fees or commissions charged on each transaction. At the end of the year, you’ll have a complete chronological record of all of your transactions in one usable format. This will make doing your taxes much easier.
Bitcoin Tax Tip #2: Beware FIFO to avoid inadvertent capital gains
One of the most common complaints I saw this year was the harsh results of First in, First out (FIFO). FIFO is a method for tracking cost basis of bitcoins that have been commingled in the same wallet, but which were purchased at different times and at different prices. Upon subsequent sale or transfer of a bitcoin out of the wallet, the IRS does not let you simply “pick” which bitcoins left the wallet and which ones stayed behind. Instead, you have to have use an established system for identifying the cost basis of each coin, and FiFo is the one generally preferred by the IRS. As the name implies, FiFO requires you to assume that the first bitcoin deposited into your wallet is the first one transferred out. This has the unfortunate consequence of triggering large capital gains, as your oldest bitcoins (the ones sold first under this system) were probably the cheapest and therefore had the lowest cost basis.
The easiest way to avoid this outcome is to keep separate wallets. Set up a cold storage wallet for the bitcoins you plan to hold long-term, a “trading wallet” for bitcoins you plan to buy/sell as the market price changes, and a “mining wallet” for mined coins. Limit how often you move bitcoins between these wallets. Using separate wallets in this manner will not only help keep your records clean and easier to reconcile, but it will also help you avoid inadvertently selling bitcoins with the lowest cost basis (which is often the result under FiFo).
Bitcoin Tax Tip #3: Make quarterly tax deposits
There’s nothing worse than owing thousands of dollars to the IRS on your tax return. Not a few bitcoin users found themselves in this predicament after they failed to account for taxes over the course of the year. Unlike your paycheck, no one is withholding taxes from your bitcoin transactions. Although you probably didn’t know it, the tax law actually requires you to make tax deposits with the IRS as a substitute for the withholding in this case. The deposits should be made quarterly and based upon an estimate of your taxable income for the year. A good rule of thumb is the start with the taxes you paid last year and make adjustments for extraordinary items or changes in circumstances. Note there is a small penalty if your estimate ends up paid last year. Your accountant or tax preparer should be able to help you figure this out.
Tax deposits are particularly important for bitcoin miners, who must recognize income for each bitcoin they mine regardless of whether the coin is ever sold. As a result, its very easy for bitcoin miners to have large tax liabilities without ever generating any cash flow. This forces miners to sell bitcoins in order to pay the tax, which can be quite painful when the price of bitcoins has declined since the tax was generated (which happened this year). Selling a portion of each bitcoin to make quarterly tax deposits would have lessened the burden of this outcome.
Tax season is always a stressful time of year. Hopefully these tips will help make the 2015 tax season and beyond a little less so.