Bitcoin lovers and haters can find at least one area of consensus: the cryptocurrency markets are exceptionally resilient. After briefly hitting an all-time record high of $5,000 in early September, the digital coin quickly unraveled. A mere two weeks later, Bitcoin prices breached the psychological $3,000 support line, leading many critics to call time.
But just when you thought that cryptocurrencies dug themselves a hole too deep, the digital-coin markets roared back.
At time of writing, Bitcoin prices are above $4,300. Against its peak level, the number-one ranked cryptocurrency is down 14%. Although the loss is still significant, it’s a dramatic improvement over what was a 40% collapse. More important, the recovery was machine-gun quick compared to traditional Wall Street assets.
With confidence towards Bitcoin prices returning, many are ready to reengage cryptocurrencies. No longer an obscure process, buying Bitcoin today has never been easier. But before you start dreaming about fancy restaurants and exotic vacations, we have to talk about “Bitcoin taxes.”
You didn’t think Uncle Sam would just let you sidestep the system, did you?
An Overview of Bitcoin Taxes
Before we dive into Bitcoin taxes, we must first define what Bitcoin is. Currently, the Internal Revenue Service defines virtual currencies as “property.” Although the IRS recognizes that digital coins are often traded like a real currency, the coins lack legal tender status.
Taxing Bitcoin as property becomes a double-edged sword. Generally speaking, most investors won’t have a problem with it because of favorable capital gains designations. For example, those holding virtual currencies for longer than one year are subject to long-term capital gains rate. In the case of most taxpayers, this rate is no higher than 15%. Short-term capital gains, or assets held less than one year, are taxed as “ordinary income at graduated tax rates,” according to the IRS.
The trickier part about Bitcoin taxes is dealing with capital losses. Currently, the IRS limits the maximum amount you can declare on any given tax year at $3,000. If your losses exceed this figure, you can carry it forward to future years. Depending on your individual situation, the process can be cumbersome, and you may need a licensed tax advisor.
Be aware that while cryptocurrencies are considered property, they are also considered income if used in business transactions. For instance, an independent contractor or an employee receiving virtual currencies in lieu of cash still is receiving income. Therefore, these transactions must be reported to the IRS as if they were originally conducted in U.S. dollars.
Nuances of Bitcoin Tax Law
From what I’ve listed so far, Bitcoin taxes don’t seem overly complicated, and in principle, they’re not. In practice, the situation becomes convoluted. It was only years after Bitcoin was first introduced that virtual-currency laws and regulations were enacted. Simply put, the law lags digital-market developments, and confusion will inevitably result.
First, the IRS only calls out Bitcoin by name. Does that mean other virtual currencies, such as Ethereum and Litecoin, are exempt? Hardly! The IRS specifies in their cryptocurrency guidelines that assets similar to Bitcoin will be treated as such. In other words, don’t get cute with the taxman.
However, what defines “similar?” The IRS hammers down on cryptos that are “convertible” virtual currencies; that is, a digital coin “that has an equivalent value in real currency, or that acts as a substitute for real currency.”
Ethereum and Litecoin are well-known assets, and are convertible directly to U.S. dollars using virtual-currency exchanges, such as Coinbase. But today, over 1,100 digital coins exist. Are they all convertible? Hardly! It’s almost as if the IRS is admitting that they don’t have the resources to tackle this growing “problem.”
Second, regulations on Bitcoin taxes don’t address daytrading. Currently, the IRS has special designations for people who engage frequently and substantially in trading securities’ daily market movements. While the IRS has made it clear that Bitcoin is not a stock, it’s also concerned about actual functionality.
If a no-name cryptocurrency were to emulate the dramatic rise of Bitcoin prices, the IRS would want its cut. Essentially, a previously non-convertible coin would suddenly become convertible due to market success. In the same vein, the IRS could potentially distinguish between crypto investors, and crypto traders. All I can say is watch this space.
Open-ended Questions Remain
Other questions exist. The biggest one is what to do with the so-called hard fork of leading virtual currencies. The IRS does not define the new Bitcoin cash, which split off from its original asset. People who received the offshoot coin should report it as “other income,” according to certified public accountant Robert A. Green. But at this time, the IRS has no official guidance.
Further compounding the issue is that the property definition of cryptocurrencies is sorely lacking. Property doesn’t spin itself off, and generate “income.” Additionally, income is something that you either actively earn or passively accrue on a frequent basis, such as dividends. The hard fork does not fit into any traditional definition of income; thus, the coins themselves should be classified as an entirely new taxable category.
Of course, we’re dealing with the government, so rarely are things logical and straightforward. As a general statement, you should make a good-faith effort in reporting your digital coins as taxable property. However, if in doubt, please consult a tax professional.
Josh Enomoto is long all the cryptocurrencies mentioned in this article, which should not be construed as tax nor legal advice.
