Bitcoin is a form of decentralized, virtual currency that was introduced in 2009. It is decentralized because transactions can occur person-to-person without the use of an intermediary like a bank or other financial institution. This allows for more private transactions and allows users to save money on banking and transaction fees. In recent years, as Bitcoin transactions have become more common, people have begun to wonder how to properly report Bitcoin gains and losses, as well as income paid for your services in Bitcoin on their tax returns. At the Tax Law Offices of David W. Klasing, our dual tax attorneys and CPAs have years of experience helping folks who buy and sell Bitcoin properly report this on their taxes, and we can help you do the same.
The “bitcoin” itself is essentially just a computer file. It is powered by an open-source code known as a blockchain. Each transaction involving the bitcoin is represented as a “block” on the “chain” of the code. High powered computers are used to verify each transaction as it becomes part of the blockchain’s permanent record. The blockchain then serves as a public ledger of all transactions involving that bitcoin, but without revealing anyone's identity.
Bitcoin has a deliberately built-in artificial scarcity as part of its system, making it impossible for more than 21 million individual bitcoins ever to exist. More than 15 million bitcoins have already been discovered through a complex, computer-based process known as mining. When all 21 million have been mined, no new bitcoins will be created. The value of bitcoin thus goes up and down with supply and demand, depending on how much bitcoin is currently available in the market.
While using virtual currency can save you money in banking fees, it does not free you from scrutiny by the IRS. In recent years as the use of this currency has risen, the IRS has become more serious about its enforcement efforts related to failure to report virtual currency on tax returns as required. The IRS defines virtual currency as a “digital representation of value” that is not recognized as the legal tender of any country. For tax purposes, this means it is classified as property, like stocks or real estate, rather than as currency, like U.S. dollars.
Virtual currency, as property, is subject to the capital gains tax. You must report all capital gains and losses on Schedule D of your tax return each year. In order to calculate these, you need to keep track of the fair market value of a bitcoin on the dates you bought each of yours. Buying bitcoin is not a taxable event, but when you sell the bitcoin or use it to purchase something, taxes will be calculated based on any capital gains. To calculate capital gains, you subtract the fair market value of bitcoin on the day you purchased it from the price at which you sell the bitcoin.
Extensive records must be kept in order to calculate all capital gains and losses properly. If you possess the bitcoin for less than a year before selling, a short-term capital gains tax will apply at the same rate as your income tax. If you possess it for a year or longer, a long-term capital gains tax will be assessed at up to 20%, depending on your income bracket. Capital losses can be written off to offset gains taxes, but you cannot be compensated more than $3,000 in a year. An experienced virtual currency tax lawyer like those at the Tax Law Offices of David W. Klasing can help you determine your tax liability and reporting requirements.
Although it is still quite uncommon, some individuals are paying employees and independent contractors in Bitcoin. If you are paid in Bitcoin, you must report this as income on your tax returns, rather than as property as you would if you bought and sold Bitcoin. If you are an employee, your employer will be required to calculate and withhold the standard payroll taxes. If you are an independent contractor, you will likely have to pay self-employment taxes on these earnings. It is best to contact a tax attorney for in-depth, individualized advice for these more complicated types of situations.
Reporting Bitcoin on your tax returns can be complicated, especially if it was paid as income to you in exchange for a service. Whenever you are dealing with virtual currency, you should reach out to a skilled tax attorney and CPA like those at the Tax Law Offices of David W. Klasing so we can advise you on when and how you need to report it to the IRS. To set up a consultation, call us today at (661) 432-1480.