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Did You Spend Bitcoin in 2017? You May Owe the IRS Money

By Matthew Frankel, CFP® - Updated Feb 22, 2018 at 2:11PM

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It’s becoming well-known that selling bitcoin at a profit is taxable, but you could also be on the hook just for spending the digital currency.

Bitcoin profits are taxable. This is becoming a well-publicized concept following bitcoin's staggering 1,400% rise in 2017.

However, many people don't realize that this doesn't only apply to bitcoin or other cryptocurrencies you've sold at a profit. If you spent bitcoin that had risen in value since you acquired it, that's also considered a profit, and it may be taxable. Here's what you need to know about the bitcoin tax rules, how much you may have to pay, and why it's important to accurately report your profits.

Hand holding a gold coin with a bitcoin symbol

Image source: Getty Images.

It's not just selling bitcoin that can raise your tax bill

Even though taxpayers are not widely reporting bitcoin transactions to the Internal Revenue Service, it's becoming widely known that selling an asset such as bitcoin at a profit results in taxable income. In other words, if you bought one bitcoin for $1,000 early in 2017 and sold it for $10,000 later in the year, you made $9,000, and it shouldn't seem too odd that the IRS wants its cut.

However, many people don't realize that spending bitcoin that has risen in value can trigger a taxable event as well. For example, if you buy a $50 dinner with bitcoin that you paid $20 for, the $30 in appreciation is considered taxable profit.

Here's why. The IRS considers bitcoin and other cryptocurrencies to be capital assets. This is the same tax classification as things like stocks, bonds, and gold. If you buy a capital asset at one price, and sell it for a higher price, the profit you earn is taxable. The same applies if you exchange it for goods or services (spend it) at a higher valuation than you paid.

How likely is it that your bitcoin purchases will raise red flags? It depends. In general, the IRS is concerned with larger taxable events. In other words, if you bought a cup of coffee with appreciated bitcoins and didn't report it, the agency is unlikely to come knocking on your door to collect a few dollars (though I still recommend reporting the gain). On the other hand, if you bought a car, precious metals, or even a fancy dinner with bitcoins that were worth significantly more than you paid for them, the odds of receiving extra IRS scrutiny increase.

How much tax will you have to pay?

How much tax you'll owe depends on three main factors -- the size of your profit, your adjusted gross income (AGI), and how long you held the bitcoins before selling or spending them.

The IRS classifies capital gains into two broad categories, short-term and long-term. A short-term gain is defined as a profit on anything held for a year or less, and a long-term gain means that you held the asset for over a year.

Short-term gains are taxed just like ordinary income, so your tax rate is based on the 2017 marginal tax brackets. On the other hand, long-term gains are taxed at more favorable rates of 0%, 15%, or 20%, depending on which ordinary tax bracket you fall into.

For example, if you are in the 25% marginal tax bracket, this would correspond to a long-term capital gains tax rate of 15%. Let's say that you'd bought some bitcoin for $500 and after it rose in value, you used it to pay for $2,000 worth of clothing, a $1,500 gain. If you held the bitcoin for longer than a year, you would pay 15% of this amount, or $225. On the other hand, if you held it for a year or less, you'd pay 25%, or $375.

The IRS is cracking down on bitcoin tax avoidance

Here's a tip: The IRS is well aware that most people haven't been reporting their bitcoin profits. As I wrote recently, of 250,000 tax returns submitted through Credit Karma as of early February, fewer than 100 (0.04% of them) reported cryptocurrency profits.

Also, the agency is taking steps to find taxpayers who have unreported cryptocurrency profits. Although it can be difficult for the IRS to trace individual bitcoin transactions, it's worth mentioning that leading bitcoin exchange Coinbase is providing 1099 forms to customers who have received at least $20,000 in cash for cryptocurrency sales and have made at least 200 transactions in a year. These forms are also sent to the IRS.

Even if this doesn't apply to you, you are still obligated to report any profits made from selling or spending cryptocurrencies. I wouldn't be surprised if the IRS used additional methods to figure out who is using cryptocurrencies and took a closer look at their tax returns.

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