How the IRS Taxes Cryptocurrency – and the Loophole That Can Lower Your Tax Bill

izmir, Turkey - September 28, 2018 Close up ethereum ripple litecoin bitcoin dash coins shot in metallic black background in studio.
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Although cryptocurrencies like Bitcoin can be used to make purchases of anything from hand-made crafts to, in the near future, a Tesla electric vehicle, if you convert that currency to cash rather than pay in the form of crypto, you could be liable for capital gains tax. “Every time you convert Bitcoin to cash it is technically a taxable event,” says Daniel Polotsky, CEO at CoinFlip, a Bitcoin ATM operator.

See: Tesla Buys $1.5 Billion in Bitcoin, Says It Will “Soon” Accept It as Form of Payment
Find: Economy Explained – How Does Cryptocurrency Work, and Is It Safe?

However, whether or not you earn money on the transaction determines whether you may have to pay capital gains tax or can declare a loss on your taxes, which could reduce your tax bill by offsetting other gains or up to $3,000 in your adjustable gross income. “Most people only think about reporting transactions when they make money,” Polotsky says. “Reporting losses can help people save on their taxes, as well.”

Track Your Crypto Transactions

That’s why it’s a good idea to keep track of all your transactions, CoinFlip advises. “To make sure you are ready for tax season, always keep a careful record of your cryptocurrency activity,” CoinFlip blogger Joey Prebys writes.

Save for Your Future

See: 8 Reasons the IRS Could Audit You
Find: What Is FICA Tax? 10 Tax Terms You Should Know in 2021

You’ll want to track all activity, including:

  • The market value of your Bitcoin
  • When it was earned, mined or purchased
  • When it was used, sold or cashed out

If you use a cryptocurrency exchange to make payments of more than $20,000 or for more than 200 transactions, you may get a form 1099-K showing the exchanges, Prebys writes. But if you don’t reach these minimums, you’ll need to track the transactions yourself and report the gains or losses on your tax forms. It can get complicated to ensure you’re taking all the deductions to which you’re entitled, including transaction fees, the cost of any apps you use and even the computer and mobile devices you use for your crypto transactions. It’s smart to consult with a tax accountant if you earned, used or traded crypto in 2020.

There’s good news for investors who are letting their Bitcoin piles grow. Right now, Polotsky explains, the IRS treats crypto as property, which means you do not have to declare existing crypto on any part of your tax return unless you withdraw it from your account, sell it or trade it. Similar to stocks and other investment assets, even if the crypto rises in value, which it has done for so many people this year, you don’t have to pay capital gains tax on it if you don’t touch it. “It doesn’t matter how high the price of Bitcoin goes up as long as it remains in your digital wallet,” says Polotsky.

See: Bitcoin’s Value Skyrockets to $1 Trillion as Price Hits $54,000
Find: Morgan Stanley May Bet on Bitcoin as It Nears $50,000 in Value

Declaring Crypto as Income

While you don’t have to declare crypto that you purchased yourself on your income taxes, much like you don’t have to declare stock purchases, you do have to declare cryptocurrency income in the tax year that you received it. If you mined it yourself or earned it as income from an employer or someone who hired you as an independent contractor, crypto is considered taxable income. If an employer pays you in crypto, according to CNBC, the employer should withhold FICA and federal income taxes just as with any pay. You’ll receive a W-2 detailing your income by the end of February. If you received it as an independent contractor, you should receive a 1099 form from the person who hired you.

Remember, though, you’re only declaring the coin’s value at the time it was received. So, if you received Bitcoin in exchange for services in January 2020, you’d declare that income as the currency’s value in January 2020. If you continue holding the Bitcoin, you don’t have to pay taxes on its current value until you convert it to cash.

Save for Your Future

See: Banks Might Treat Bitcoin Like ‘Real Money’ – These Experts Weigh the Pros and Cons
Find: Long-Term Investors Hold Most of the Bitcoin Supply

Using Crypto for Purchases

But what happens if you realize capital gains when you use crypto to make a purchase? For instance, you purchased $8,000 in Bitcoin and it’s now worth $80,000, which you plan to use to purchase a Model X through the Tesla website. You could owe tax on $72,000 in capital gains once the crypto leaves your digital wallet. “Going explicitly by the tax code, if someone has a gain on their cryptocurrency and uses it to pay for a product, they would have to pay capital gains taxes similarly to other investment vehicles,” Polotsky explains.

However, because using Bitcoin for mass market purchases remains a new endeavor, Polotsky says, “It is unclear how the federal government will treat such purchases. Many tax implications will depend on whether these purchases are treated as Bitcoin-to-cash transactions or Bitcoin-to-Bitcoin transactions.”

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About the Author

Dawn Allcot is a full-time freelance writer and content marketing specialist who geeks out about finance, e-commerce, technology, and real estate. Her lengthy list of publishing credits include Bankrate, Lending Tree, and Chase Bank. She is the founder and owner of GeekTravelGuide.net, a travel, technology, and entertainment website. She lives on Long Island, New York, with a veritable menagerie that includes 2 cats, a rambunctious kitten, and three lizards of varying sizes and personalities – plus her two kids and husband. Find her on Twitter, @DawnAllcot.
How the IRS Taxes Cryptocurrency – and the Loophole That Can Lower Your Tax Bill
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