Historically, the stock market has been the best creator of long-term wealth. Though it's undergone numerous corrections and bear markets, it's still returned an average of 7% per year, inclusive of dividend reinvestment and adjusted for inflation. For most investors, this means a doubling of their invested nest egg about once every decade, which isn't too shabby at all.
That was until cryptocurrencies came along. Last year, the combined market cap of all digital currencies rose from $17.7 billion at the beginning of the year to $613 billion by years' end. For you math-phobes out there, that's a better than 3,300% increase, which might very well be the best single-year performance for any asset class, ever.
Bitcoin is making people rich
As you might have imagined, bitcoin led the charge higher. After beginning the year at $967 per coin, bitcoin surged, at one point, to nearly $20,000 per coin and a market cap well in excess of $300 billion. As the most traded cryptocurrency in the world, and the one accepted by more merchants than any other digital coin, it's become the face of the crypto craze.
Bitcoin has also been a source of incredible profits for investors -- especially those who've held over the long run. For instance, the Winklevoss twins' initial investment of $11 million was actually worth more than $1 billion when bitcoin neared the $20,000-per-coin mark. Of course, most folks aren't tossing $11 million into bitcoin. Instead, the average holding tends to be a little over $2,900, according to a November survey from online student loan marketplace LendEDU. Then again, the value of bitcoin has more than doubled since this November survey, suggesting that the average holding today would be closer to $6,000, assuming no one sold.
More than a third of bitcoin investors will commit blatant tax fraud this year
However, this great source of profits is also a major source of confusion come tax time. Forget for a moment the fact that more than half of all people have no clue whether or not bitcoin is legal to own in the U.S., and just imagine how little people know about bitcoin's tax status. Capital gains and losses should be (key word there) reported by taxpayers to the Internal Revenue Service (IRS) on Form 8949, even though bitcoin isn't regulated or recognized as legal tender in the United States. But history has shown that most taxpayers aren't doing this.
According to the IRS, just 802 taxpayers reported capital gains or losses on their tax returns in 2015, which is pretty consistent with the number of reporting taxpayers between 2013 and 2014. But according to a recently won court case, far more taxpayers were likely basking in profits and not reporting them. A legal victory against cryptocurrency exchange Coinbase is requiring the exchange to turn over information on 14,355 users who traded at least $20,000 worth of bitcoin between 2013 and 2015. In the process, the IRS made it clear that it was going after crypto tax evaders.
Yet bitcoin investors don't really seem to care, or understand the law for that matter. When LendEDU questioned 564 bitcoin investors in November whether they'd be reporting their capital gains or losses on their 2017 taxes, just 64% affirmed that they would. This means 36% of bitcoin investors plan to knowingly and willingly commit tax fraud by evading capital gains tax in the upcoming tax season.
This capital-gain tax avoidance is even more blatant if these profits were taken in the short-term (defined as holding an investment for 365 days or less). Short-term profits are taxed at the ordinary income-tax rate, which is higher than the long-term capital gains tax rate.
Of course, even law-abiding bitcoin investors are in for a challenge. According to Fortune, bitcoin exchanges have yet to provide investors with Form 1099, which is critical to properly logging their cost basis and sales. In addition, bitcoin has forked multiple times, spinning off numerous other virtual currencies, including bitcoin cash. These assets must be accounted for as well.
The GOP tax law just closed a major bitcoin tax loophole
Not only has the IRS signaled that it's done playing games with bitcoin investors who choose to avoid paying their fair share of capital gains tax, but the recently passed GOP tax law also addressed a major loophole that had allowed some investors the ability to avoid the IRS's grasp.
In the previous version of the U.S. tax code, which came to an end on Dec. 31, 2017, bitcoin investors leaned on a provision known as "like kind exchanges" that allowed them to avoid paying capital gains tax. These investors could diversify their holdings by exchanging their bitcoin for other cryptocurrencies, like Ethereum, Litecoin, or Ripple, and claim to the IRS that they made no capital gain in the process.
However, a new change in the language of the GOP's tax law ensures that bitcoin investors (and cryptocurrency investors as a whole) can no longer use the like kind exchange loophole to their advantage in order to escape capital gains tax. The tax section in question replaced the word "property" with "real property," which will now require cryptocurrency investors to report their gains anytime they dispose of a virtual currency for a profit (or loss). It also means they'll pay tax when converting cryptocurrencies back into U.S. dollars, or even when buying goods or services.
As tempting as it might be to sweep those crypto-profits under the rug, don't! The IRS is getting serious about cryptocurrency tax evaders and it appears ready to step up enforcement in the months and years to come.