8 Bitcoin Tax Facts to Know

Bitcoin is a decentralized digital currency that has gained in popularity since its debut in 2009. Bitcoin, and other cryptocurrencies, have attracted investors looking for an alternative to traditional physical currency.

While your clients may want to invest in Bitcoin to further diversify their portfolio, there are numerous tax implications that accompany owning such an asset.

Are you advising your clients correctly when it comes to their investments in digital currencies?

In the gallery above are eight important tax and financial planning questions and answers advisors should be aware of regarding the taxation of Bitcoin, according to ALM’s Tax Facts Online and the Internal Revenue Service.

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1. What is Bitcoin?

Bitcoin and other cryptocurrencies are a type of virtual currency that has an equivalent value in real currency (and can often act as a substitute for real currency) so that it is often referred to as a convertible virtual currency. It can be digitally traded between users or converted into other types of currencies (including U.S. dollars). Cryptocurrencies are not “legal tender” of public debt in virtually all jurisdictions worldwide, specifically including the U.S.A.

(Image: Shutterstock)

2. How are Bitcoin and other forms of virtual currency taxed?

Virtual currency transactions are taxable by law just like transactions in any other property. Taxpayers transacting in virtual currency may have to report those transactions on their tax returns. When you sell virtual currency, you must recognize any capital gain or loss on the sale, subject to any limitations on the deductibility of capital losses.

The cryptocurrency tax rate for federal taxes is the same as the capital gains tax rate. It ranges from 10-37% for short-term capital gains and 0-20% for long-term capital gains in 2021. Crypto-asset gains are calculated using income and how long the cryptocurrency was held.

(Image: Shutterstock)

3. When is the fair market value of Bitcoin used in a sale or exchange transaction determined?

For purposes of determining the value of Bitcoin received that must be included in gross income, the fair market value is determined as of the date the Bitcoin is received by the taxpayer. As in other property transactions, this fair market value forms the “basis” of the Bitcoin as of that date.

The taxpayer must determine the value of the Bitcoin in U.S. dollars. This means that the basis of Bitcoin will typically be its acquisition cost. In the case of a gift or inheritance of Bitcoin, the basis of the Bitcoin in the hands of the donor will presumably apply (this issue has not yet been formally addressed in official guidance).

(Image: Shutterstock)

4. How does a taxpayer identify which Bitcoin or other virtual currency are involved in a sale, exchange or other disposal of the virtual currency?

In many cases, taxpayers own multiple pieces, or units, of the same type of virtual currency that were acquired at different times and at different costs. When a taxpayer does not dispose of all units of the type of virtual currency, the 2019 FAQ on virtual currency transaction provides that taxpayers are entitled to choose which specific pieces of virtual currency will be deemed part of the transaction.

This election can be made either by (1) documenting the specific currency unit’s unique digital identifier such as a private key, public key, and address, or (2) by records showing the transaction information for all units of a specific virtual currency, such as Bitcoin, held in a single account, wallet, or address.

(Image: Shutterstock)

5. How does a taxpayer report a transaction in which Bitcoin or other virtual currency is involved?

For the first time ever, the IRS asked about cryptocurrency transactions on taxpayers’ 2020 Form 1040 federal income tax returns. The question asks the taxpayer if they received, sold, sent, exchanged, or otherwise acquired any financial interest in any virtual currency at any time during 2020.

However, the IRS also released guidance clarifying that taxpayers who purchased cryptocurrency with “real” currency are not required to answer the question with a “yes” if they had no other cryptocurrency transactions during the tax year because a taxpayer who merely owns cryptocurrency is not taxed on any gains or losses until they sell or otherwise exchange the cryptocurrency. In other words, there has been no realization event that would trigger tax liability.

Dispositions of Bitcoin as property must be reported to the IRS in the same manner as any other intangible property transactions, meaning that the taxpayer will be required to complete and file Schedule D and Form 8949, or Form 4797, to report the transaction in accordance with the instructions to those forms.

(Image: Shutterstock)

6. What considerations apply when an employer pays employees or independent contractors using Bitcoin or other virtual currency?

If a taxpayer receives Bitcoin as compensation for services provided as either an employee or an independent contractor, the value of that Bitcoin is treated as either wages or self-employment income, depending upon the circumstances. The fair market value on the date of receipt will be subject to withholding (including FICA and FUTA taxes) and treated as any other compensation received by an employee (and must be reported on Form W-2).

(Image: Shutterstock)

7. What are some of the advantages and disadvantages of using Bitcoin or other virtual currency?

What are some of the advantages and disadvantages of using Bitcoin or other virtual currency? As with any other type of transaction, there are advantages and disadvantages to using Bitcoin or other virtual currency as a method of payment. With Bitcoin, transaction costs for transferring the virtual currency can be lower than costs charged by a financial institution or credit card company.

Further, Bitcoin can be transferred internationally with few complications, and without many of the fees that can apply when converting currency. Bitcoin can also be useful in developing countries that lack a secure banking system or stable currency.

(Image: Bloomberg)

8 Bitcoin Tax Facts to Know

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1. What is Bitcoin?

2. How are Bitcoin and other forms of virtual currency taxed?

3. When is the fair market value of Bitcoin used in a sale or exchange transaction determined?

4. How does a taxpayer identify which Bitcoin or other virtual currency are involved in a sale, exchange or other disposal of the virtual currency?

5. How does a taxpayer report a transaction in which Bitcoin or other virtual currency is involved?

6. What considerations apply when an employer pays employees or independent contractors using Bitcoin or other virtual currency?

7. What are some of the advantages and disadvantages of using Bitcoin or other virtual currency?

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8 Bitcoin Tax Facts to Know

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More on this topic

1. What is Bitcoin?

2. How are Bitcoin and other forms of virtual currency taxed?

3. When is the fair market value of Bitcoin used in a sale or exchange transaction determined?

4. How does a taxpayer identify which Bitcoin or other virtual currency are involved in a sale, exchange or other disposal of the virtual currency?

5. How does a taxpayer report a transaction in which Bitcoin or other virtual currency is involved?

6. What considerations apply when an employer pays employees or independent contractors using Bitcoin or other virtual currency?

7. What are some of the advantages and disadvantages of using Bitcoin or other virtual currency?

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