Cryptocurrencies Can Involve Capital Gains and Income Taxes
How does the Internal Revenue Service handle Bitcoin taxes? Like most questions for the IRS, the answer is, it depends. But with recent cryptocurrency prices soaring to new heights, you might like an answer that’s a little more clear. We’ll try to un-muddy the waters.
What Is Cryptocurrency?
A cryptocurrency, or virtual currency, uses digital files for money instead of bills and coins. The files are encoded using cryptography, a complex, scientific method of scrambling information to hide it from unauthorized users. Cryptocurrency is decentralized, independent of any government.
Bitcoin is the most well-known cryptocurrency, created in 2009. When trading first started in July 2010, a Bitcoin sold for somewhere between less than a penny and 8 cents. Just this week, one Bitcoin sold for more than $36,000. A note of caution: virtual currency prices have crashed at various times as well.
Bitcoin Taxes: Capital Gains
Bitcoin was created to function as a regular currency to buy and sell things. But the IRS considers it to be property, akin to stocks and bonds. And just like stocks and bonds, you have to pay capital gains tax on the profit you make when you trade it away. That could mean cashing it in for actual currency or another virtual currency by using an exchange. You can also show a gain when you buy something using Bitcoin – say you bought one Bitcoin for $10,000, and then used it to buy a car worth $30,000.
And just like all capital gains, you’ll pay short-term or long-term capital gains tax depending on how long you owned the cryptocurrency you’ve sold. If you’re trading specific coins, you’ll use the amount you paid for them to determine your profit or loss. But most Bitcoin holders have made many, many transactions. In that case, the IRS insists on using the FIFO (first-in, first-out) method of valuation. In other words, your oldest coins (probably the lowest-cost ones) are considered to be the first coins you sell.
Bitcoin Taxes: Income Tax
When someone pays for your work using cryptocurrency, that pay is subject to income tax. The taxable amount is based on the fair market value (FMV) of the cryptocurrency when you receive it. If it’s your regular employer paying you in Bitcoin, the earnings are subject to Social Security and Medicare, too.
You can earn Bitcoin by “mining” as well. Bitcoin mining uses sophisticated computer gear to perform complex math computations. Those computations serve to keep track of Bitcoin transactions for the system as a whole. Again, the tax is based on the FMV when you earn it.
No Taxes for Just Owning Cryptocurrency
If you buy Bitcoin and just hold it in your digital wallet, you don’t owe any tax.
Good Records Are Vital
Most cryptocurrency traders make hundreds of transactions, so detailed records are a must. To figure out your profit or loss on a trade, you must know the date you bought or earned your coins and their FMV at the time. There are various software programs you can use to track your trades, or using a spreadsheet is another option.
The IRS has an FAQ on virtual currency.
CryptoTrader.Tax has an in-depth article on cryptocurrency taxes and transaction tracking.
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