We’ve created this page as basic primer to help you learn the tax principals applicable to bitcoin. Keep in mind that these tax principals also apply to other cryptocurrencies as well.
How is crypto classified for tax purposes?
In Notice 2014-21, the IRS ruled that “virtual currencies” are classified as “property” for federal income tax purposes. This means that bitcoin is subject to the general principals of taxation that apply to all types of property. There are no special rules or treatment for virtual currency.
As property, bitcoin qualifies as a “capital asset” in the hands of most taxpayers. An important exception is if the bitcoin is held as inventory for sale in the taxpayer’s trade or business (see Section 1221 of the Internal Revenue Code for a list of the other exceptions). As long as such an exception does not apply, any gain or loss realized upon exchange of bitcoin is “capital” in nature and eligible for the preferred long-term capital gains.
Lastly, here are a few things that bitcoin is not (at least for federal income tax purposes):
- Foreign Currency
- Share of Stock or a Security
What is the tax treatment of buying, selling, or exchanging crypto?
As a consequence of bitcoin’s classification as “property,” every exchange of bitcoin is a taxable transaction. This includes exchanges of bitcoin for cash, for goods/services, and even for other altcoins.
It is irrelevant whether or not the transaction involved fiat. If an exchange occurred, and as a result of that exchange the taxpayer gave up bitcoin and received something other than bitcoin in return, then a taxable transaction has occurred.
Therefore, US taxpayers must calculate the amount of their gain or loss on every single transaction involving bitcoin. This is highly burdensome and threatens the widespread adoption of bitcoin (or virtual currency in general) as a viable medium of exchange.
Gains are calculated by taking the “amount realized” in each transaction and subtracting the “cost basis” of the bitcoins given up. If the amount realized was greater than the cost basis, there is a gain. If it was not, then there is a loss. The total amount of gains and losses are then netted against each other to determine the net gain or loss for the year. Any tax preparation software will automatically perform these calculations.
Here is some more information on the tax treatment of buying, selling, and exchanging bitcoin:
- Cost Basis: “Cost basis” is the original value of an asset for tax purposes, and is usually equal to the purchase price of the property given up in a transaction. In the case of bitcoin, tracking cost basis gets difficult if bitcoins that were purchased at different times and at different amounts are kept in the same wallet. The default system (and the one generally preferred by the IRS) is to assume that the bitcoins are sold in the order they were acquired. Thus, the first bitcoin purchased is assumed to be first bitcoin sold. This is called the FIFO method (“First in, First Out”). There are some other methods available, such as LIFO (“Last In, First Out”) and Average Cost Basis, but it’s not clear if bitcoins are eligible for these alternatives.
- Amount Realized: In the case of a sale, amount realized is equal to sales price, reduced by any selling costs incurred in the transaction (like commissions or wire transfer fees). In the case of an exchange of bitcoins for goods or services, then amount realized is the value of the goods or services received in the exchange. In most cases, this would be the price of the goods/services as denominated in fiat currency.
- Reporting gains/losses: Generally speaking, reporting capital gains from the sale/exchange of bitcoin is the same as other types of capital assets (such as shares of stocks). So, net short-term and long-term capital gains are reported on Schedule D of Form 1040. The individual transactions themselves are reported on Form 8949. If there is a high volume of transactions, they can be reported on a separate statement and attached to Form 8949 instead. Note that each and every individual transaction must be reported on Form 8949 or an attached statement.
What is the tax treatment if mining crypto?
In Rev. Ruling 2014-12, the IRS confirmed that bitcoin mining is a taxable activity. Specifically, bitcoin miners have taxable income at the time they successfully mine a bitcoin. The amount of this income is equal to the market price of the mined bitcoin. This will also be the miner’s cost basis in the mined bitcoin if it is ever sold in the future.
The method of reporting income from bitcoin mining will depend on whether the mining activity rises to the level of a “trade or business” or is merely a “hobby.”
If a mining activity qualifies as a trade or business, then the income and expenses are reported on Schedule C. According to the IRS, a trade or business is an activity engaged in for profit, which the taxpayer conducts on a regular, continuous, and substantial basis. This is a highly factual test and the results will vary depending on the unique factors of each situation.
If a mining activity does not qualify as a trade or business, then it is considered “hobby income” and reported Line 21 as “other income.” Mining expenses for hobby income have to be deducted separately on Schedule A as a miscellaneous itemized expense.
Each method has advantages and disadvantages depending on the circumstances. If you need assistance determining which is best for you, schedule an appointment for a tax consultation to speak with our tax attorney.
Do crypto transactions qualify as like kind exchanges under Section 1031?
Beginning January 1, 2018, only real estate transactions can qualify as “like kind exchanges” under Section 1031. This is due to a change in the law under the Tax Cuts and Jobs Act passed at the end of 2017.
For transactions occurring before 1/1/2018, the short answer is “maybe.” There is no current guidance from the IRS on the qualification of crypto as like kind property, nor are there any regulations or court decisions directly addressing the issue. This means that a taxpayer who elects to adopt like-kind treatment is at risk of having the IRS deny such adoption, which would result in the taxpayer having to pay back taxes, plus interest and penalties.
One option for such a taxpayer is to obtain an opinion letter from a tax attorney prior to adopting like-kind treatment. If done correctly, the opinion letter can shield the taxpayer from penalties in the event the IRS rejects the taxpayer’s use of like-kind deferment under Section 1031.
Lastly, even though exchanges of like-kind property are tax-free, they still must be included on the tax return. Specifically, like-kind exchanges are reported using Form 8824.
This information does not constitute legal advice and you should not act upon the information provided below without obtaining specific advice from an attorney. No representation or warranty is given as to the accuracy or completeness of the information provided below, and we do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on this information for any decision based on it.
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