Cryptocurrencies have become increasingly popular, with last year's bitcoin boom paving the way to an explosion in attention for the digital token and its peers. Even those who put modest amounts of money into crypto-assets several years ago have seen huge profits.
Yet what many crypto-investors are only now learning is that bitcoin and other tokens can be subject to tax. Those who have made transactions in bitcoin or other cryptocurrencies need to take care to comply with tax rules governing their holdings, or else the IRS will be more than willing to clamp down on anyone trying to avoid making tax payments. Below are five reasons why you might owe tax from your bitcoin or other cryptocurrency holdings.
Image source: Getty Images.
1. You sold bitcoin for cash
The most obvious situation in which you'll owe tax on your cryptocurrency profits is when you sell your bitcoin in exchange for U.S. dollars. The IRS treats bitcoin and other cryptocurrencies as capital assets, which means that when you initially buy bitcoin, the amount you pay becomes its tax basis. Any increase in value between then and the time you sell it becomes capital gains, taxable at preferential long-term rates if you held the cryptocurrency for longer than a year, or ordinary short-term rates if you held it for a year or less.
2. You bought something using bitcoin
Many people think of bitcoin as a form of currency, and so buying something with it might not ordinarily seem like a taxable event. But because the IRS sees bitcoin as a capital asset, it treats buying something with bitcoin as if you had sold the cryptocurrency in exchange for the value what you bought. So if you initially obtained a bitcoin for $1,000 and then used it to buy a car worth $10,000, you'll owe tax on the $9,000 difference -- again treated as a capital gain depending on how long you've held the bitcoin.
3. You traded bitcoin for other cryptocurrency
Many bitcoin investors argued that if they took their holdings and traded them for other types of cryptocurrencies, they were making a like-kind exchange that would allow them to defer their taxes. Not all tax experts agree that the rules governing like-kind exchanges ever actually applied to bitcoin and other crypto-assets. For 2018, Congress made things much clearer by limiting like-kind exchanges to real estate.
4. You got paid in bitcoin as compensation
Finally, if you took bitcoin or other cryptocurrencies in exchange for work that you did, then what you received will be subject to tax just like any other wages or salary you receive as compensation. You'll need to include the value of the bitcoin as of the day you were paid as ordinary income. Moreover, if you received bitcoin in exchange for work that you did separate from any formal employment that you have, then the proceeds can be treated as self-employment income, potentially subjecting you not only to income tax but also the payroll taxes on Social Security and Medicare that apply to self-employment income. Rates on bitcoin received as compensation are typically higher than the capital gains rates that apply to investment holdings in cryptocurrencies, so this is a situation in which tax planning can be even more important than usual.
Be ready for IRS scrutiny
Because of the huge gains in cryptocurrencies in 2017, the IRS is focusing more of its attention than ever on bitcoin and other digital tokens to make sure it gets every bit of tax that crypto-asset owners owe. If you've made money from bitcoin, you'll want to be extremely careful to comply with the rules governing your profits. If you don't, you could find yourself on the receiving end of a particularly nasty IRS audit in the near future.
