The Internal Revenue Code (IRC) is a long way from catching up with cryptocurrency, but the IRS already has some rules in place for Bitcoin taxes. In 2014, the IRS published a notice on virtual currency (Notice 2014-21) stating that virtual currencies such as Bitcoin are treated as property for federal tax purposes. The IRS does not treat cryptocurrency as currency. That means your cryptocurrency transactions are viewed differently from the transactions you might make between foreign currencies. Instead, Bitcoin transactions are taxed just like any other general property.
Many of the regulations will not apply if you set up your cryptocurrency investment in an IRA. Cryptocurrency investments in an IRA or Roth IRA follow the same tax regulations as other IRA investments. As long as you are at least 59.5 and have had the account for five years or more, all withdrawals from a ROTH IRA are tax-free. If you have a traditional IRA, then your withdrawals are taxed as regular income based on your tax bracket that year.
Even though IRS rules on cryptocurrency may not apply to you directly, it is prudent to know what is happening in the tax world. Taxation impacts the market and changes investor behavior, so Bitcoin taxes can indirectly affect the long-term value of your IRA.
Any Purchase Made With Cryptocurrency Is Taxable
This rule has surprised many investors. Because the IRS categorizes Bitcoin and other cryptocurrencies as property rather than currency, non-retirement investors can be taxed for every transaction. If you use Bitcoin to buy pizza, exchange it for Litecoin, or any other purchase, then the IRS counts it as a capital gain or loss. Defining cryptocurrency as property decreases the convenience of cryptocurrency.
The record-keeping can be burdensome. Coinbase and a few other exchanges send investors a 1099-K tax form, but investors are on their own at many exchanges. You are responsible for keeping track of all transactions – even if the exchange shuts down. As an IRA investor, you do not have to worry about the tracking and paperwork because your tax is calculated differently. At the same time, convenience may be a factor in public acceptance and the long-term growth prospects of cryptocurrency.
Buying Other Cryptocurrencies With a Cryptocurrency Is a Capital Gain (or Loss)
If you use Ethereum to purchase Litecoin, then you have created a taxable event. This is how many of the crypto exchanges are set up. Just be aware that every time you exchange one coin for another outside of an IRA account, you will generate a profit or loss that you have to report to the IRS. Sheltering from this rule is a tremendous benefit to investing in cryptocurrency within an IRA. IRA investors do not have to pay taxes on each exchange, leaving more money in your account.
How the IRS Calculates Fair Market Value
The fair market value of virtual currency on a currency exchange where the exchange rate is determined by supply and demand is calculated by converting the virtual currency to US dollars at the current exchange rate. If the exchange is in a foreign country, then the cryptocurrency can be turned into that country’s currency, then converted into US currency.
Short vs. Long-Term Gains
Like other assets, cryptocurrencies are taxed at a higher rate if they are held less than a year. The downside is that you may not be able to deduct losses in future tax years. Here again, IRA investors have a significant advantage. You pay fewer taxes both now and later. However, Bitcoin taxes impact the emerging crypto market, so it is essential to stay aware of any changes even if your investments are not directly affected.
Accounting Method for Bitcoin Taxes
The IRS has not stated a preferred accounting method for Bitcoin taxes. First-in, first-out (FIFO) seems to be the most common, but check with your tax lawyer to determine the best method for your situation. When you use FIFO, calculate your gains starting with the first purchase you made.
For example, say you made three purchases of a coin:
January 27, 2015: 500 coins for $10,000 ($200 each)
March 16, 2016: 300 coins for $9,000 ($300 each)
September 3, 2017: 200 coins for $8,000 ($400 each)
Then you sold 400 coins on January 1, 2018, for $700 each. The FIFO method would calculate your capital gain as the $28,000 you received (400 * 700) less the $8,000 (400 * 200) you spent on January 27, 2015, for a net gain of $20,000.
Enforcement Is Increasing
The IRS is eager to take its share of the money generated by cryptocurrencies. Coinbase received a federal court summons in February 2018 requiring it to turn over taxpayer numbers, names, and transaction records for 13,000 customers.
More Changes Soon
Stay tuned for more changes from the IRS regarding Bitcoin taxes. As a taxpayer, you have the right to comment on IRS regulation development by emailing Comments@irscounsel.treas.gov and including “Notice 2014-21” in the subject line.
If you have any questions about cryptocurrency, taxes, and IRS rules, contact us at BitTrust IRA. We are working to make sure our clients understand the complexities, guidelines, and rules, and have the right information in a sector that is growing and changing daily.