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Do You Need to Pay Taxes On Bitcoin?

April 07, 2015  |   Tax Advice,Tax Scams   |   Tags: , ,  

Bitcoin is a virtual currency invented by Satoshi Nakamoto in 2008. Bitcoin uses encryption to make transactions secure and is operational worldwide. It is not, however, backed by the federal Treasury in the U.S. or by any government in the world. In a transaction of bitcoins, two people can make a transaction without an intermediary. There is no central repository or an administrator controlling the system. Due to this feature of bitcoin, the U.S. Treasury has categorized it as a decentralized virtual currency. Bitcoin does not use any physical material such as paper or metal, and is purely electronic. It is the world’s first decentralized digital currency.

taxes on bitcoin

Bitcoins have become popular among criminals who fund black market transactions, fraud, and various other illegal activities. Accordingly, governments and financial institutions have come forward to place restrictions on bitcoin usage. If you own bitcoin or make bitcoin transactions on a regular basis, it’s wise to understand their governing regulations. Investopedia talks about the current status of bitcoin in the eyes of the Federal Reserve and the IRS, and what reporting and tax laws you are required to follow:

“Bitcoin is now listed on exchanges and has been paired with leading world currencies such as the US dollar and the euro. The US Federal Reserve acknowledged the growing importance of bitcoin when it announced that bitcoin-related transactions and investments cannot be deemed illegal. At the start bitcoin’s attractiveness was attributed partly to the fact that it wasn’t regulated and could be used in transactions to avoid tax obligations. The virtual nature of bitcoin and its universality also make it harder to keep track of in cross-country transactions. In addition, government authorities around the world soon realized that bitcoin attracted black marketers who could make illegal deals. Naturally, it was impossible for bitcoin to escape the tax authorities’ radars for long.

“Around the world, tax authorities have tried to bring forth regulations on bitcoins. The US Internal Revenue Service (IRS) and its counterparts from other countries are mostly on the same page when it comes to treatment of bitcoins. The IRS said that the bitcoin should be treated as an asset or an intangible property and not a currency, as it is not issued by central bank of a country. Bitcoin’s treatment as an asset makes the tax implication clear.

“The IRS has made it mandatory to report bitcoin transactions of all kinds, no matter how small in value. Thus, every US taxpayer is required to keep a record of all buying, selling of, investing in, or using bitcoins to pay for goods or services (which the IRS considers bartering). Because bitcoins are being treated as assets, if you use bitcoins for simple transactions such as buying groceries at a supermarket you will incur a capital gains tax (either long-term or short-term depending on how long you have been holding the bitcoins). When it comes to bitcoins the following are different transactions that will lead to taxes:

  • Selling bitcoins, mined personally, to a third party.
  • Selling bitcoins, bought from someone, to a third party.
  • Using bitcoins, which one may have mined, to buy goods or services.
  • Using bitcoins, bought from someone, to buy goods or services.

“Scenarios one and three entail mining bitcoins, using personal resources, and selling them to someone for cash or equivalent value in goods and services. The value received from giving up the bitcoins is taxed as personal or business income after deducting any expenses incurred in the process of mining. Such expenses may include the cost electricity or the computer hardware used in the mining of bitcoins. Thus, if one is able to mine 10 bitcoins and sell them for $250 each. You have to report the $2500 as taxable income before any deductible expenses.

“Scenarios two and four are more like investments in an asset. Let’s say bitcoins were bought for $200 each, and one bitcoin was given up in exchange of $300 or equivalent value in goods. The investor has gained $100 on one bitcoin over the holding period and will attract capital gains tax (long-term if held for more than one year, otherwise short-term) on $100 earned by selling/exchanging the bitcoin.

“If bitcoins are held for a period of less than a year before selling or exchanging, a short-term capital gains tax is applied, which is equal to the ordinary income tax rate for the individual. However, if the bitcoins were held for more than a year, long-term capital gains tax rates are applied. In the US, long-term capital gains tax rates are 0% for people in 10%-15% ordinary income tax rate bracket, 15% for people in the 25%-35% tax bracket, and 20% for those in the 39.6% tax bracket. Thus, individuals pay taxes at a rate lower than the ordinary income tax rate if they have held the bitcoins for more than a year. However, this also limits the tax deductions on long-term capital losses one can claim. Capital losses are limited to total capital gains made in the year plus up to $3000 of ordinary income.

“However, taxation on bitcoins and its reporting is not as simple as it seems. For starters, it is difficult to determine the fair value of the bitcoin on purchase and sale transactions. Bitcoins are very volatile and there are huge swings in prices in a single trading day. The IRS encourages consistency in your reporting; if you use the day’s high price for purchases, you should use the same for sales as well. Also, frequent traders and investors could use ‘first in, first out’ (FIFO) or ‘last in, first out’ (LIFO) accounting techniques to reduce tax obligations. (Refer to the Bitcoin Tax Guide for a detailed explanation of issues in Bitcoin Taxation and reporting.)”