Behind Bitcoin – A Closer Look at the Tax Implications of Cryptocurrency
By Nathan Goldman and Christina Lewellen
On January 1, 2016, a single Bitcoin was valued at a price of $432. Only five years later, the price of a Bitcoin has ballooned to over $40,000 – with extreme price fluctuations on a daily basis.
With Bitcoin’s dramatic rise in price and popularity, many individuals have realized significant gains in the ownership of these assets. While Bitcoin is often referred to as a cryptocurrency, its label is misleading. The confusion over what exactly Bitcoin is – and how it is treated – can lead to significant tax implications.
In this article, we discuss some important questions that Bitcoin investors or users may face.
What is bitcoin, and is it a “currency?”
Bitcoin is a virtual asset operated by a decentralized authority. Said another way, it is an asset that can be used to buy and sell other assets or property that is not governed by a country or entity. Bitcoin does not exist physically. Instead, any transaction involving Bitcoin occurs electronically and only after substantial computing power. Bitcoin is a type of ‘cryptocurrency’ in the same way that ‘Kleenex’ is a type of tissue. There are many other cryptocurrencies that exist, although Bitcoin is the most widely known.
While Bitcoin and other cryptocurrencies are often referred to as a “currency,” all but a few countries in the world tax the exchange of this asset like property. In this way, buying and selling Bitcoin is really more like trading gold, stocks or other assets than using a traditional currency. There are no tax implications when one buys something with a traditional currency, like the U.S. dollar, but every time you sell Bitcoin or use it to purchase something, it results in a taxable transaction. So while some may believe that Bitcoin will someday replace local currencies, this is unlikely due to the market frictions of tax implications each time it is traded. In other words, the significant ease by which transactions can be undertaken using local currency transactions (e.g., cash, debit cards) – as compared to the complexity and tax implications of Bitcoin transactions – make every day purchasing more difficult when using Bitcoin.
What are the tax implications of Bitcoin transactions?
Since Bitcoin is taxed as property, every time you buy something with Bitcoin, you have to keep a record of purchase and pay a gains tax on the difference between the purchase price and sales price. This concern is particularly important given Tesla’s recent announcement that they will soon accept Bitcoin as payment for their vehicles.
For example, if you plan to buy a car for $45,000 – and the seller accepts Bitcoin – and your Bitcoin is currently valued at $45,000, then you can conceivably exchange one Bitcoin for your car. However, the transaction is treated as though you exchanged your $45,000 of Bitcoin for $45,000 of cash, and then used that cash to buy the vehicle. This becomes an issue for two reasons:
- Bitcoin has increased in value substantially in recent years. If you bought this Bitcoin one year ago, you may have spent as little as $5,000. If you then exchange $45,000 of Bitcoin for cash, this will trigger a $40,000 capital gain on the asset’s sale, which is the difference between the price of the Bitcoin exchanged and the purchase price. This capital gain can be either short-term (if held for one year or less) or long-term (held for greater than one year) and can lead to significant tax costs. Short-term capital gains are taxed on individuals’ ordinary income rates, which currently range from 10% (for single individuals with income under around $10,000 per year) up to 37% (for single individuals with income over about $520,000). Current long-term capital gain tax rates are 0% for those with total taxable income under approximately $40,000, 15% for those with total taxable income between approximately $40,000 and $450,000, and 20% for those with total taxable income over approximately $450,000. So if you held the Bitcoin for less than one year and your tax rate is 25 percent, when you use the Bitcoin to purchase the car in the above example – which resulted in a $40,000 gain – you would owe $10,000 in taxes on the transaction when you file your tax return.
- This tax treatment with Bitcoin varies substantially from executing the same transaction with cash because no gain would need to be recognized with a cash transaction. Even though cash can fluctuate in value, currency fluctuations do not trigger gains or losses in the same way property does. At the beginning of 2020, Congress introduced a de minimis rule, proposing that cryptocurrency transactions of $200 or less would not be subject to tax. However, at this time, no progress has been made on this proposal.
Is the IRS going to know when I sell or pay for things with Bitcoin?
The answer to this question is…maybe. If you sell Bitcoin via an exchange such as Coinbase, and your total transaction amounts during the year are over a certain threshold (for Coinbase it’s 200 transactions or $20,000), then similar to other capital-market transactions like stock sales, the brokerage is required to send you a tax form (Form 1099) at year-end. Gains and losses will be subject to taxation. As in any other Form 1099, the broker also sends this information to the IRS. The IRS will match your income to what you report on your personal tax return. Should this information not align, the likelihood of your tax return being audited goes up dramatically. And should you be found guilty of underpaying your taxes, you will have to repay that amount plus a penalty.
Unique from other securities that a taxpayer may hold, Bitcoin transactions can be handled solely by the investor. Currently, if you exchange Bitcoin through a means other than an exchange – like a person-to-person exchange platform – or you use Bitcoin to purchase a commodity, the IRS will not receive information about your Bitcoin transactions. And, just because the taxpayer is not issued a Form 1099 because the transaction occurs independent of a broker, this does not excuse the taxpayer from paying the appropriate income taxes. It is important to note that you are still responsible for reporting the transactions on your tax return at year-end, even if you do not receive a tax form about the sales. Failing to do so can result in significant penalties, including negligence penalties. In addition, there is a new question on individual tax forms that asks taxpayers if they sent, exchanged, or acquired any virtual currency (see Schedule 1), and the taxpayer is required to answer “yes” or “no.” Thus, if you select “yes” to this question, the IRS will be looking for cryptocurrency transactions in your tax return. In the event you selected “no” when you actually had cryptocurrency activity, and if the IRS discovers this activity, you can be subject to severe penalties that can range up to $100,000 for fraud charges, and potentially face tax evasion charges that could result in imprisonment.
In sum, even if you do not receive a Form 1099, it is critical for Bitcoin users to report their transactions on their tax returns to avoid trouble with the IRS. But keep in mind that buying and selling Bitcoin does not only generate gains. Should your transactions generate a loss, the loss can reduce your tax liability. In sum, whether it is to ensure that you are reporting enough income or lower your tax liability, it is important to correctly report your Bitcoin transactions.
What records do I need to keep for Bitcoin transactions?
For a Bitcoin investor or user to successfully maintain their records, he or she must track the purchase price of the Bitcoin (i.e., the Bitcoin’s “basis”) and the price of any Bitcoin at the time it is sold, exchanged or used to purchase commodities.
While some Bitcoin users may receive a Form 1099 from their broker at the end of the year, it is ultimately up to the taxpayer to report the correct amounts. Importantly, if you do receive a Form 1099, this tax form will report your gross proceeds – that is, the gross amount you received from the sales – not your taxable gain. If you do not receive tax forms for some or all of your Bitcoin transactions, you will need to keep track of the gross amount of Bitcoin sold, exchanged or used to purchase commodities. This amount will be your gross “sales proceeds.” Then you will need to match these “sales” with the purchase price of the Bitcoin, and the difference between these two amounts will be the taxable gain.
What are the risks associated with Bitcoin that potential investors or users should consider?
Bitcoin creates important risks for users and investors – some of which are very unique to virtual currencies. People considering investing in Bitcoin, or those who consider using it as an alternative to traditional currencies, should weigh these risks with its potential benefits.
First, Bitcoin is highly volatile. The price swings in this asset are extreme, which could – in some cases – result in large losses, especially for people who need continuous access to a liquid currency for daily transactions. We recommended that if you do choose to invest in Bitcoin, you do not only invest in Bitcoin, and, instead, employ a diversified portfolio. This would involve having some high-risk investments that provide potentially high returns (e.g., Bitcoin), medium-risk investments that provide good returns (e.g., Index Funds) and some low-risk investments that provide small returns (e.g., bonds).
Second, the structure of Bitcoin is very different from traditional stock or a bank account where there is an owner-of-record. Instead, Bitcoins are characterized by an identifying number, rather than an owner. The transactions are also not reversible due to the technology that underlies them. Therefore, if they are hacked, if you make a transaction by accident, or if you naively authorize a transaction where someone else gains access to your Bitcoin, these transactions are difficult or impossible to reverse. Therefore, users must use extreme caution in their transactions. In addition, you must carefully keep records of your Bitcoins, because if you lose the identifying numbers, they may be impossible to retrieve.
Third, while some may view the lack of regulation and autonomous management as a benefit of Bitcoin, this unregulated, decentralized nature also creates risks. If things do go awry, there is not one management group or individual to hold responsible. Moreover, the lack of regulation and anonymity of not having an identifying owner associated with Bitcoin also creates opportunities for illicit transactions. To the extent that governments crack down on illicit activities through Bitcoin in the future, it is not clear how it would affect demand for this asset. In addition, it is very likely that IRS reporting and tracking of Bitcoin transactions will increase substantially as time goes on. Thus, opportunities for tax evasion with this asset will likely decrease, and it is uncertain how a reduction in opportunities for evading taxes would affect demand for this asset.
Finally, the future of Bitcoin is very uncertain at this point in time. Right now, the transaction and tax costs associated with holding and using Bitcoin for purchases are much more cumbersome compared to other more traditional assets and currencies, and for this reason, it is unlikely unless this changes that Bitcoin would become a viable replacement for traditional currencies. In sum, it is unclear what the long-run prospects of this asset are.