Understanding the Tax implications of investing in Bitcoin and other Cryptocurrencies
The beginning of 2020 created a unique moment for retail trading: Increased market volatility, stay-at-home orders, and zero commission fees across all trading platforms created a surge in activity and an increase in first-time traders. According to a CNBC article “these first-time traders, many in their 20s and 30s, found the stock market accessible. High prices had kept many on the sidelines for years. As sports events were canceled, sports betting was replaced with stock trading.” The NYPOST reported that “more than 6 million new customers traded cryptocurrency for the first time on Robinhood from the start of the year through mid-February,” Bitcoin is getting more mainstream as investment bank brokerages (such as Goldman Sachs) are now starting to offer it to wealthy clients and traditional banks are helping investors put their money into cryptocurrency funds. Companies like Tesla and Square are hoarding Bitcoin. And celebrities are leading the way in a digital-art spending spree using a technology called an NFT.
And the New York Times just reported that on April 14th, 2021 digital or cryptocurrencies took their biggest step yet toward wider acceptance when Coinbase, a start-up that allows people to buy and sell cryptocurrencies, went public.
According to another recent article from CNBC, after a relatively quiet few years following a short-lived surge in 2017, the price bitcoin (a virtual cryptocurrency) skyrocketed again in late 2020, finishing the year with a single coin worth just shy of $30,000. The frenzied rally sparked many investors to invest in the cryptocurrency for the first time, while others who had been holding onto their bitcoin for some time took advantage of the token’s exploding price to sell some of their holdings for a profit.
A recent article from CNN also discusses the recent surge in bitcoin “if you couldn’t resist getting in on bitcoin’s wild ride in 2020 — it went up about 680% over the past year and has been trading north of $55,000 recently — let’s hope you kept good records, because you are responsible for preserving documentation for every one of your transactions.”
But with tax filing season upon us, some users will come face-to-face with the fact that they now owe taxes on those gains. Depending on when you bought and sold your bitcoin — as well as other factors, such as your income — you could be on the hook to pay.
How does the IRS view Bitcoin and Cryptocurrencies?
Even though you can buy things with bitcoin, it’s not the same as cash. At least not in the eyes of the IRS.
Virtual currencies are taxed as property, or as an investment, when you sell them. And using them to buy something counts as selling.
If you’re paid in bitcoin, on the other hand, that will be treated as taxable income to you.
Indeed, almost every transaction may be taxable and should be reported. Self-employed individuals with Bitcoin gains or losses from sales transactions also must convert the virtual currency to dollars as of the day received, and report the figures on their tax returns.
If you are an employer paying with Bitcoin, you must report employee earnings to the IRS on W-2 forms.
- You must convert the Bitcoin value to U.S. dollars as of the date each payment is made and keep careful records.
- Wages paid in virtual currency are subject to withholding to the same extent as dollar wages.
While bitcoin and other cryptocurrencies may be virtual, they have very real-world tax consequences. If you fail to pay the tax you owe, you will be subject to interest and penalties and, in some circumstances, even criminal prosecution. TurboTax published an article that states that the IRS answered some common questions about the tax treatment of virtual currency transactions in its recent IRS Revenue Ruling 2019-24 and its Frequently Asked Questions article. Tax treatment depends on how a virtual currency is held and used.
The Internal Revenue Service plans to alter the standard 1040 form by putting this question on the front page: At any time during 2020, did you sell, receive, send, exchange or otherwise acquire any financial interest in any virtual currency? The taxpayer must check the box “Yes” or “No.”
How cryptocurrency investors can lower their capital gains tax obligations
A recent Bloomberg Opinion article by Alexis Leondis, asks the question, “are you among the estimated 15% of Americans who own digital currency?” She further stated “if you sold or traded it last year, you’re probably sitting on big gains, and those will come with hefty tax bills.”
The Bloomberg Opinion article goes into explaining that there are smart ways to manage those tax obligations, and not-so-smart ones, too.
The article mentions that a lot of crypto investors might be tempted to drag their feet when it comes to tax planning and it’s easy to see why. The tax issues are complex. One reason is because this is a new asset class, brokerage firms don’t do the hard work of tracking their holdings, as they typically do for owners of stocks and bonds. Guidance from the IRS can be confusing, too. But throwing up your hands is not a solution.
It seems like only a few short years ago that many taxpayers were simply not understanding that there were tax implications related to trading Bitcoin or any other digital currencies. It wasn’t until 2014, that the IRS stated “crypto was considered property for tax purposes, like stocks, and would therefore be subject to capital-gains taxes when sold or traded.” And as I wrote about in an article about the Gamestop, Robinhood frenzy back in February, If investors hold anything that’s considered property for under a year, it’s taxed at short term capital gains-ordinary income tax rates. If it’s held for longer, it generally qualifies for lower long-term capital gains tax rates.
Another way of looking at it iis If you owned your bitcoin for more than a year, you will pay a long-term capital gains tax rate on your profit, which is determined by your income. For single filers, the capital gains tax rate is 0% if you earn up to $40,000 per year, 15% if you earn up to $441,450 and 20% if you make more than that. This IRS worksheet can help you do the math. If you owned your crypto for less than 12 months, the taxes you pay will be the same as your normal income tax rate.
An article in The Balance mentions that ‘as with other types of property, you would acquire it first, often by exchanging cash for the asset. You then own the property for a period of time, and you might eventually sell it, give it away, trade it, or otherwise dispose of it. Capital gains taxes come due at this point.
Four things will happen when property is disposed of:
- Income is realized from any gain.
- Gain is measured by the change in the dollar value between the cost basis or purchase price and the gross proceeds received from the disposition or the selling price.
- The tax rate that applies depends on whether the property was held for one year or less (a short-term gain) or for more than a year (a long-term gain).
- Disposition of property is reported on your tax return using Schedule D and Form 8949 or Form 4797. These forms require that you “show your math” when you’re calculating a gain or loss. You’ll do your calculations right on the form, per instructions.4
So the Bloomberg Opinion writer basically explains that people now understand that there are taxes for this trading investment and are now trying to figure out strategies to questions such as “how to reduce the capital gains tax owed, or at least how to pay it later?”
Defer Capital Gains by investing in Opportunity-zone funds
The Bloomberg Opinion article points out that one strategy that some investors are using to defer crypto tax bills for 2020 is to invest in an opportunity-zone fund. A provision in the 2017 tax law allows taxpayers to defer, and even reduce, capital gains taxes if they put the proceeds from the sale of say, a stock or business, into a fund created to promote investment in an economically disadvantaged area. Investors generally have six months to move the money.
According to Ryan Losi, an CPA in Richmond, Virginia, he says that “proceeds from crypto sales qualify, too, and people who sold crypto toward the end of last year can still cut their 2020 capital-gains tax bills by acting now.”
Under the rules, they’ll be able to defer their capital gains tax until 2026, and if they hold the investment beyond that, cut their tax bill by as much as 10%.
Tax Strategies for Next Year
For next year’s tax season, investors who happen to be philanthropically inclined and itemize their deductions may want to donate their gains to a charity (provided the nonprofit accepts crypto, although there are third parties that can help if not). That’s doubly advantageous because the donor both escapes the capital-gains tax and gets a deduction for the full market value of the crypto holding up to a certain percentage of income, as long as it was held for at least one year, said Nicholas Marazza, an accountant at Marcum LLP.
Buy Crypto using a Self Directed IRA
Another possible tax strategy, investors should research relates to purchasing digital currencies or crypto in a self-directed Individual Retirement Account. Any trading of the currencies within the account wouldn’t be subject to capital gains tax — taxes would just be triggered when the money is withdrawn. Pay attention to the fees though, which are typically higher than a traditional IRA.
How Trading Crypto is Different than Stocks for Tax Purposes
One final piece of advice, that Bloomberg Opinion article wants investors to remember is that there is an advantage that crypto owners have over stock investors: cryptocurrency doesn’t have a wash sale rule, which bars stock investors from taking a deduction for a loss if they repurchase the same security within 30 days. A Charles Schwab article explains “the wash-sale rule was designed to prevent investors from selling a security at a loss so they can claim tax benefits, only to turn around and immediately buy the same security again.”
So as the end of 2021 approaches, a crypto investor can sell unrealized losses by Dec. 31, 2021, to offset some gains, and then buy the crypto back in early 2022.
Basically your tax strategy may be every bit as important as your investment strategy. And here’s what not to do: use current crypto holdings as collateral to acquire a new crypto asset. Some investors do this in part because it avoids triggering capital gains tax, since they aren’t selling or exchanging anything. But it’s a dangerous tactic because it’s banking on no market downturn. Crypto markets are way too volatile to make that a good bet.