Are There Taxes on Bitcoin?

More than a decade after Bitcoin’s introduction, there is still considerable confusion about its taxes. Cryptocurrency was conceived as a medium for daily transactions but has yet to gain traction as a currency. Meanwhile, it has become popular with speculators and traders interested in making a quick buck off its volatility.

The Internal Revenue Service addressed cryptocurrency transactions in its notice 2014-21. The agency stated that cryptocurrencies would be treated as an asset similar to property. In 2020, the IRS began including a question on its Form 1040 to determine whether the taxpayer had any cryptocurrency transactions during the given tax year.

Depending on the type of transaction, assets are subject to various kinds of taxes. However, the unique characteristics and use cases for Bitcoin mean that there are many exceptions with continually evolving tax legislation.

Bitcoins & Taxation: An Overview

Bitcoin is now listed on exchanges and has been paired with leading world currencies, such as the U.S. dollar and the euro. The IRS deems virtual currency as a digital representation of value separate from the representation of a U.S. dollar or foreign currency, Virtual currency—whether Bitcoin, Ethereum, or smaller altcoins, are treated as property and general tax principles typically apply to these assets.

Gains or Losses on Sales of Bitcoin

When you sell virtual currency, you must recognize capital gains or losses on the sale of the asset. The gains or losses recognized are subject to limitations on the deductibility of the taxpayer's capital losses. This tax legislation is determined by IRS Publication 544 (Sales and Other Dispositions of Assets). Capital gains are reported on Schedule D of a taxpayer's Form 1040.

In the most broadest sense, gains and losses on the sale of Bitcoin are treated the same as other capital assets such as stocks, bonds, precious metals, or certain personal property, Long-term capital gains are often taxed as ordinary income and assessed at the same tax rate as the taxpayer's salary or wages. Long-term capital gains are often taxed at a more favorable rate that varies on the taxpayer's tax status as well as their income.

Below are the capital gain rates for 2022 as well as 2023.

Bitcoin Taxable Transactions

The IRS has provided specific guidance on transactions involving digital assets that are to be included in a tax return. Note that the extent of these transactions may make for difficulty to track all transactions; cryptocurrency investors and users are advised to see tax advisor guidance on ensuring all of the following transactions are adequately being captured:

• Sale of a digital asset for fiat
• Exchange of a digital asset for property, goods, or services
• Exchange or trade of one digital asset for another digital asset
• Receipt of a digital asset as payment for goods or services
• Receipt of a new digital asset as a result of a hard fork
• Receipt of a new digital asset as a result of mining or staking activities
• Receipt of a digital asset as a result of an airdrop
• Any other disposition of financial interest in a digital asset
• Receipt or transfer of a digital asset for free (without providing any consideration) that does not qualify as a bona fide gift
• Transferring a digital asset as a bona fide gift if the donor exceeds the annual gift exclusion amount
  

Bitcoin Tax Basis

In its broadest sense, the tax basis of Bitcoin used to determine your gain or loss is the cost in which the digital currency was obtained. For example, assume 100,000 Satoshi was acquired when Bitcoin was trading at $20,000/coin. The cost basis of the acquisition would be $20.

In the example above, should the Bitcoin be sold for $25, a $5 taxable gain would occur. If the Bitcoin were sold for $14, a $6 loss would occur.

The tax basis of Bitcoin becomes more complicated as less-straightforward transactions occur. For example, it may be of no cost for an investor to receive airdropped tokens or tokens in exchange for a service. In most of these situations, Bitcoin (or other digital currencies) would have a basis equal to the fair market value at the time of acquisition. This tax treatment is similar to that of stocks and bonds.

Tax Implications of Bitcoin Mining

Cryptocurrency mining is also considered a taxable event. The fair market value or cost basis of the coin is its price at the time at which you mined it. The good news is that you can make business deductions for equipment and resources used in mining. The nature of those deductions differs based on whether you mined the cryptocurrencies for personal or individual gain.

If you run a mining business, then you can make the deductions to cut down your tax bill. But you cannot make these deductions if you mined the cryptocurrencies for personal benefit.

Tax Implications of Swaps

Some have argued that conversion of one cryptocurrency to another, say from Bitcoin to Ether, should be classified as a like-kind transfer under Section 1031 of the Internal Revenue Code. The IRS allows you to defer income tax on such transactions.

However, in a Memorandum from the Office of Chief Counsel released on June 18, 2021, the IRS ruled that such exchanges do not qualify as a like-kind exchange under Section 1031. What's more, the Tax Cuts and Jobs Act (TCJA) of 2017 put an end to that practice by clarifying that like-kind transfers are restricted to property transactions.

If you receive cryptocurrency in a transaction performed via an exchange, the value of the digital currency received is recorded by the exchange at the time of the transaction. If the transaction is performed off-chain, the basis of the exchange is the fair market value of the exchange. Otherwise, the centralized or decentralized exchange will have record of the basis on its distributed ledger.

Tax Implications of Hard Forks

Hard forks of a cryptocurrency occur when a blockchain split occurs, meaning there is a change in protocols. A new coin, with differences in mining and use cases from its predecessor, is created. Holders of the original cryptocurrency may be given new coins. This practice is also known as an airdrop and is also used as a marketing tactic by developers of new coins to induce demand and usage.

In a 2019 ruling, the IRS clarified that hard forks do not result in gross income, if the wallet holder does not receive units of cryptocurrency. Airdrops, on the other hand, qualify as gross income after the holder receives units of a new cryptocurrency either after a hard fork or by marketers of a coin. In the latter case, the quantity and time at which a crypto wallet holder receives the new coins determines the tax amount. Airdrops are taxed as ordinary income.

Tax Implications of Gifting Bitcoin

Cryptocurrency donations are treated in a similar fashion as cash donations. They are tax-deductible, though donors face limits on how much they can deduct based on their AGI. An appraiser will assign a fair market value for the coin based on its market price at the time of donation. The donor is not required to pay any taxes on the price gain.

The IRS established an annual gift tax exclusion every year. In 2022, taxpayers are allowed an annual exclusion per donee for a gift amount of up to $16,000. For 2023, this limit has been increased to $17,000.

Special Considerations

The volatility of bitcoin price makes it difficult to determine fair value of the cryptocurrency on purchase and sale transactions. It is strongly advised to track transactions as they occur, as retrospectively needing to obtain financial information (even on distributed ledgers) may prove to be difficult.

It is also difficult to use identify the appropriate accounting method for use in cryptocurrency taxation. Last In, First Out (LIFO) and Highest In, First Out (HIFO) have the potential to decrease taxes but the IRS has approved very few instances of their use for crypto traders. First In, First Out is the most commonly-used method for cryptocurrency accounting.

Cryptocurrency donated to a charitable organization will often not result in a taxable transaction. The basis of the donation is often the fair market value of the digital currency at the time of the transaction.

The Bottom Line

Cryptocurrency is an exciting, volatile, risky, and emerging market. Those investing, trading, or transacting with Bitcoin should take care to know the tax implications of their digital currency moves. Most transactions trigger taxable events, and the tax basis of the Bitcoin possessed is usually either the cost basis at acquisition or the fair market value at acquisition. Knowingly not remitting taxes on cryptocurrency transactions is considered tax fraud.