The rapid rise of Bitcoin (BTC 2.54%) within the last few months has many investors drooling over the possibilities of getting rich. But before you drift off in fantasyland and dump all your money into the cryptocurrency, don't forget to add taxes to the equation.
As a Bitcoin investor, taxes can be triggered for a variety of reasons. But not every move you make in the cryptocurrency market leads to a tax bill. Here's a breakdown of what you need to know about Bitcoin taxes to ensure you are on good terms with the IRS.
Buying Bitcoin does not impact your taxes
First, it's important to know that you won't sound off the IRS alarm if you purchase Bitcoin from a cryptocurrency exchange and hold it.
Under U.S. tax law, Bitcoin is deemed as property instead of currency. That means the profits on your Bitcoin are subject to capital gains taxes. These taxes are only applicable when you realize the gains in your account. In other words, you don't have to worry about taxes until you dispose of your Bitcoin.
Let's say you bought some Bitcoin for $13,000 and that three months later, the value of that Bitcoin had risen to $20,000. That's a $7,000 unrealized gain because you have not sold your Bitcoin. You can't officially lock in gains until you sell and obtain the benefits of the growth in your account.
So, there's no need to write a check to the IRS when you buy Bitcoin and your portfolio grows. You'll only need to dive into capital gains taxes on your Bitcoin investment when you buy at one price and sell at a higher price, leading to income in your account because of your decision to sell. This is exactly how gains on stocks work.
You'll trigger taxes when you sell or convert Bitcoin
As long as you hold your Bitcoin, you won't owe any cash to the IRS. But if you decide to sell or exchange Bitcoin for another cryptocurrency, you need to prepare to report these transactions on your tax return and potentially pay taxes.
Let's start off by diving into the tax implications of selling your Bitcoin. If you purchased Bitcoin for $13,000 and sold it for $20,000 three months later, you have a $7,000 short-term capital gain. Your profits will be taxed just like ordinary income, leading you to the popular marginal tax rate brackets that could climb as high as 37%. Similar to trading stocks, anytime you hold an asset for a year or less before selling it, you will have to pay short-term capital gains rates on your profits.
But if you're willing to hold on to your Bitcoin for over a year before selling, you'll take advantage of the lower long-term capital gains rates. These rates are 0%, 15%, and 20% depending on your income, giving you a greater opportunity to reduce your tax bill.
If you jumped into Bitcoin to avoid missing out and the price fell two months later, you'll have a capital loss if you decide to sell. This loss can offset your other gains in your portfolio, allowing you to reduce your taxable income and keep more profits in your pocket.
Then, there's a chance you may want to exchange shares of your Bitcoin for another cryptocurrency to rebalance your portfolio. Let's say you exchange Bitcoin for Ethereum. That's a taxable event because you are disposing of some or all of your Bitcoin to acquire an interest in Ethereum.
Disclosure requirements when you purchase Bitcoin
Reporting responsibilities can get a bit tricky. The IRS added a new question on Form 1040 of the tax return that asks taxpayers, "At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?"
The IRS provided more clarity to this statement by confirming that if a Bitcoin investor simply purchased "virtual currency with real currency" in 2020, there is no requirement to answer yes to the Form 1040 question. However if you sold Bitcoin or exchanged Bitcoin for another cryptocurrency, you need to check the box according to the latest IRS virtual currency update.
As fast as the price of Bitcoin can rise or fall, the rules of the cryptocurrency tax requirements can change as well. Work with a knowledgeable tax professional or CPA, review the IRS guidance, and track your transactions to ensure that you're checking the box on all the items you need to be crypto-compliant. Knowing that you're on good terms with the IRS makes your Bitcoin investing journey more rewarding.