Bitcoin (CRYPTO:BTC) made a stunning comeback toward the end of 2020, leaving many investors with triple-digit percentage gains that could impact their tax returns if they sold and took profits. Although receiving income is a slam dunk for investors, it also creates a tax liability in most cases. 

So, if you've bought or sold cryptocurrencies and have no idea what your reporting responsibilities are, take note of these three items to get you started in the right direction. 

A man holding virtual Bitcoin tokens

Image source: Getty Images. 

1. Selling Bitcoin is a taxable event

For those who wanted to learn more about cryptocurrency, Bitcoin provided a unique opportunity to "earn while you learn" and grab mega profits. But if you bought Bitcoin and sold it at a price that is higher than what you paid for it, you're on the hook for taxes. Since Bitcoin is considered property instead of currency in the eyes of the IRS, you'll be subject to capital gains taxes. These taxes are a bit different than the tax rates you see when you earn income from working a job. 

Here's a quick primer on capital gains taxes. If you bought Bitcoin for $12,000 and sold them at $20,000, you've earned an $8,000 capital gain. There are two flavors of capital gains taxes: short-term and long-term.

If you hold your Bitcoin for a year or less, you'll be taxed at short-term capital gains rates, which is the same as your normal income tax rate. But cryptocurrency investors who hold their assets for longer than a year will gain access to favorable long-term capital gains rates based on their income. These rates are 0%, 15%, and 20%, and are shown below.  

2021 long-term capital gains tax brackets

For single filers with taxable income of

For married joint filers with taxable income of

For heads of households with taxable income of

...this is the long-term capital gains rate

$0 to $40,400

$0 to $80,800

$0 to $54,100

0%

$40,401 to $445,850

$80,801 to $501,600

$54,101 to $473,750

15%

Over $445,851

Over $501,601

Over $473,751

20%

Data source: IRS. 

2. You need to disclose Bitcoin activity on your tax return 

The IRS wants to know about your cryptocurrency transactions. In fact, the IRS is making its curiosity known on the front page of the tax return. If you take a look at Form 1040, you'll notice the question, "At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?"

You are required to answer yes or no to the cryptocurrency question. Then, you'll need to disclose your cryptocurrency activity on Form 8949. This is where you will report the date you acquired Bitcoin, sold it, the sales price, cost basis, and gain or loss. In order to complete this form and any other Schedules required for crypto reporting, you'll need to keep good documentation. We'll go into that next because documentation is essential if you plan to be a Bitcoin investor. 

3. Make sure you document all Bitcoin transactions 

If you haven't documented any of your cryptocurrency transactions, taxes may become a nightmare -- especially if you trade Bitcoin hundreds of times a year. Moreover, if you use Bitcoin to buy things, each purchase is also treated as a taxable sale. This is when you'll need to weigh the pros and cons of doing your own taxes versus hiring a professional

As a Bitcoin investor, you'll need to track how much you paid for it, the U.S. dollar value of how much you sold it for, and how long you held on to the cryptocurrency before you sold it. All of this plays a vital role in how much you'll owe in taxes, so you don't want to get careless with your record keeping. Since this process is a bit tedious, many Bitcoin investors lean on cryptocurrency tax software to automate the reporting process.

Be prepared before you file your taxes 

You'll pay taxes on your profits for the year you sold your Bitcoin. If you haven't sold any of your Bitcoin investment or if you sold it at a loss, you won't owe any taxes yet. But you will still have to disclose whether you've engaged in cryptocurrency activity on your tax return.

This is just a glimpse of what you'll need to know about cryptocurrency taxes; the IRS offers virtual currency guidance that goes into more detail. Investing in Bitcoin may have come with many rewards but don't let those perks cause you to turn a blind eye to taxes, or you'll be penalized later. 

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.