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Staying Compliant: Is Bitcoin Trading Taxable?

Staying Compliant: Is Bitcoin Trading Taxable?
The Siliconreview
08 January, 2020

Beginners to Bitcoin may be confused as to whether they need to pay taxes on their Bitcoin and, if so, how to do it. In the US, Bitcoin is taxable, even though many people thought that Bitcoin would be a way to hide money from the IRS and avoid taxes on their money. In the last few years, changes in taxes have made it so that Bitcoin does need to be counted when doing taxes and, if this is not done or is not done correctly, the person may end up with huge penalties for their mistake. Instead, it's important to understand tax implications before purchasing any Bitcoin to ensure taxes paid are minimized as much as possible. Read on to learn how Bitcoin is taxed and how to prepare for tax time.

For the IRS, Bitcoin is an Asset

As far as the IRS is concerned, Bitcoin is considered an asset. While there are some exceptions to this where Bitcoin is considered income, for most purposes, those who trade Bitcoin will count it as an asset when they're preparing taxes. All taxes must be reported in US dollars, so the person preparing their taxes will need to determine the fair market value of Bitcoin and use that amount when determining the gains or losses throughout the year. This can get confusing, as there are no real guidelines on how to determine the fair market value, just that it needs to be consistent. Those who want to learn more about why the IRS counts Bitcoin as an asset can look at xCoins now.

Why is Bitcoin Considered an Asset?

Trading currencies is very different from trading cryptocurrency because of the way Bitcoin and other cryptocurrencies are handled in current tax laws. The main reason for this is that cryptocurrencies are not issued by a central bank of any country. They're a virtual currency with no physical backing from a bank. As such, they can't be counted the same as fiat currencies. Instead, the IRS has decided that it counts as an asset, similar to other types of intangible property that someone can invest in and sell at a later date. This means that Bitcoin would be handled under capital gains for tax purposes, which can have a big impact on the overall taxes someone pays to the IRS each year.

Understanding Capital Gains

Capital gains are gains made on investments. With Bitcoin, this is any money that is gained between buying and selling Bitcoin. For users of Bitcoin, this means tracking how much the Bitcoin value was when they purchased the currency as well as how much it was worth for every transaction they do after the purchase. If they buy something with the Bitcoin, they'll need to record this to determine the capital gains or losses for the Bitcoin. If they sell the Bitcoin, any profits will count as capital gains. Any losses will count as capital losses. Right now, all transactions using Bitcoin must be counted here, no matter how large or small it might be.

Determining Gain or Loss

Taxpayers will need to determine if they have any capital gains or losses through the year based on their Bitcoin use. If they purchase Bitcoin but do not spend anything or sell it, they do not have capital gains or losses to report as they haven't done anything with the Bitcoin yet. Once they trade the Bitcoin or purchase something with it, they will need to determine if they have gains or losses as well as whether they're short-term or long-term.

If the value of Bitcoin increased between obtaining the currency and selling or making a purchase, it's a capital gain. If the value of Bitcoin decreased, it's considered a capital loss. Since the value of Bitcoin can be volatile, it's crucial to pay attention to the value at the time of purchase as well as when the Bitcoin is traded or used to buy something. Proper record-keeping can make it easier to determine gains and losses throughout the year.

Short-Term Versus Long-Term Gains

Capital gains and losses can be short-term or long-term, both of which are calculated differently when it's time to file taxes. If the Bitcoin was obtained and then sold or used for a purchase within one year, it's considered a short-term gain or loss. If, however, the taxpayer held onto the Bitcoin for at least a year, it's considered a long-term gain or loss.  Short-term gains are taxed as ordinary income according to the taxpayer's tax bracket. Long-term gains can be taxed at 0$, 15%, or 20%, depending on the taxpayer's income. Holding onto the Bitcoin for more than a year is generally a good way to lower taxes, but there are limits on this for taxpayers to be aware of if they are claiming capital losses.

When Bitcoin Can Count as Income

Bitcoin is generally counted as an asset, but it is possible for it to count as income. This generally comes into play when someone is mining Bitcoin. They will not have to pay taxes if they mine the Bitcoin and hold onto it. However, as soon as they sell the mined Bitcoin to someone else or they use it to purchase something, it will be taxed as personal or business income. When this does happen, it is possible to deduct any expenses used when mining the Bitcoin. Since this is a resource-heavy operation, the taxpayer may be able to deduct expenses related to purchasing new computer hardware or the electricity used during mining.

What Happens After Theft

One thing Bitcoin owners may want to be concerned about is what happens if the Bitcoin is stolen. While Bitcoin is designed to be secure, theft has happened and can be a huge issue for those who use Bitcoin. New tax regulations, unfortunately, mean that it isn't possible to deduct for the theft of the Bitcoin. This means that taxes will need to be paid according to the amount of Bitcoin sold or used in the last year, but there is no way to protect against losses due to theft.

How to Prepare for Tax Time

Taxpayers who start preparing for filing taxes well ahead of time will find it's easier to report their Bitcoin use throughout the year as everything will be ready for them. This means they'll need to keep records of every purchase, all Bitcoin mined, and any time they used or sold their Bitcoin. It also means determining what they'll use to determine the fair market value of the Bitcoin. Since Bitcoin can fluctuate significantly through the year, it's a good idea to figure out what to use as the fair market value from the beginning, so the records will all be ready to use at the end of the tax season.

Record-Keeping for Bitcoin

Record-keeping is crucial for those who trade Bitcoin. Every transaction needs to be recorded, so it's available to reference when it's time to do taxes. If the person uses a platform to purchase and sell Bitcoin, they likely have a simple way to record all of their transactions. Since they may end up holding onto the Bitcoin for a significant amount of time, the person may want to download any information pertaining to their records so it is stored in multiple places, just in case anything happens. This is also crucial if they do not use a platform that offers record-keeping, as they'll want to be able to easily see everything they need to file their taxes.

What Counts as Fair Market Value

At the beginning of the year or before filing taxes, it's a good idea to determine the accounting method used for the fair market value of any trades. The IRS does not have any requirements for this, other than it needs to be consistent. This means that taxpayers can choose their own method for determining the fair market value. Common choices include first in, first out or last in, first out. These can have different implications during tax time, so it's crucial to determine which one will help minimize taxes paid.

Getting Professional Help with Taxes

When it comes to Bitcoins, handling taxes may not be easy. There are a lot of variables, and making a mistake can prove to be very costly if the IRS notices the mistake. For taxpayers, this means it might be a good idea to have professional help before filing taxes. Excellent record-keeping makes it easy for the professional to go through everything and determine how the Bitcoin is applicable to capital gains, whether anything counts as income, and more. Professional help can reduce the amount the taxpayer will need to pay because of Bitcoin and help them understand how to handle the Bitcoin in the future.

If you've traded Bitcoin during the year, it needs to be accounted for in your taxes. Failing to do so could lead to penalties and fines from the IRS. While Bitcoin is a currency, it is considered an asset by the IRS, so regulations surrounding assets should be used to determine how to pay taxes on Bitcoin. Use the information here and seek help if needed to file your taxes properly and avoid any potential issues.