Reports that Tesla had purchased $1.5 billion in bitcoin recently took over the news, bitcoin’s price soared, and people began to wonder – will I really be able to purchase that red Model S (long range, of course) with cryptocurrency?
Not quite yet. Many, as Tesla CEO Elon Musk demonstrated, believe cryptocurrency will soon be at the forefront of all transactions. Others, including Treasury Secretary Janet Yellen, are more skeptical. No matter which side of the debate you stand on, the rise of cryptocurrency was evidenced through bitcoin's valuation of over $51,000 U.S. dollars on February 18, 2021.
Before investing or trading in that bitcoin for your newest purchase, you’re probably going to want to ask yourself this: how is cryptocurrency taxed?
Virtual Currency and Currency: What’s the Difference?
In 2019, the IRS sent letters to around 10,000 taxpayers who improperly reported their use of virtual currency. Virtual currency does have to be included when you file taxes – but many are unsure of how to report it correctly. This could be partially because the name “virtual currency” itself is a bit misleading.
Virtual currency doesn’t function like the currency we are accustomed to — that is, it doesn’t function like the U.S. dollar. For example, when you trade in cash for a car, you’ve already paid tax on the cash when you earned it as income. If you trade in cryptocurrency for a car, there are additional taxes to pay because the cryptocurrency is technically a type of investment with capital gains and losses.
So, what is virtual currency, really, and how does it function?
Virtual Currency According to the IRS
In Notice 2014-21, the IRS explains that although virtual currency is not legal tender, it is a “digital representation of value that functions as a medium of exchange.” Some variants of cryptocurrency, called convertible virtual currency, serve “as a substitute for real currency” and can be traded, purchased, sold, and converted into U.S. dollars.
One of the most common examples of convertible virtual currency is bitcoin. Bitcoin is additionally considered cryptocurrency because it is recorded on a ledger using cryptography.
Cryptocurrency isn’t legal tender, or synonymous with the U.S. Dollar. That’s why for tax purposes, the IRS treats cryptocurrency as property. They state that “general tax principles applicable to property transactions apply to transactions using virtual currency” (Notice 2014-21).
The IRS page "Frequently Asked Questions on Virtual Currency Transactions" and Notice 2014-21 list in detail the ins and outs of cryptocurrency transactions. I’ve summarized some highlights from these documents below.
Cryptocurrency and Capital Gains
Reporting cryptocurrency is similar to reporting capital gains made from stocks, bonds, or other investments. When you hold virtual currency as a capital asset, any capital gains or losses must be reported as you file taxes. If the virtual currency was held for less than one year, it is categorized as short-term capital gain or loss. More than a year is considered long-term.
While short-term capital gains are taxed at your income tax bracket, there are additional rates for long-term capital gains. If you have any long-term gains, it is important to note that the tax rates have slightly increased in tax year 2021.
- If taxable income falls below $40,400 for single or married – filing separately filers or below $80,800 for joint filers, the tax rate is 0%.
- If taxable income falls at or above $40,400 for single filers or $80,800 for joint filers, the tax rate is 15%.
- If taxable income falls at or above $445,850 for single filers, $250,800 for married – filing separately, or $501,600 joint, the tax rate is 20%.
Your “holding period” is what determines whether your gain is short-term or long-term. The holding period begins the day after the virtual currency is acquired and lasts until you sell, exchange, or otherwise dispose of it.
Gains and losses are not just a result of trading or selling your cryptocurrency, you must also document gains or losses that occurred as a result of exchanging your virtual currency for services or other forms of property (Model S, here we come).
Paying Taxes on Cryptocurrency: Case Study
I know this is a lot of information, so let’s dive into a hypothetical case study and break it all down.
According to Yahoo Finance, the closing price on bitcoin on January 31, 2019, was $3,457.79. For the sake of this example, we’ll round to $3,457.00. Let’s say I purchased 10 bitcoins on that date. I will have paid $34,570.00 to acquire 10 bitcoins. Therefore, $34,570.00 is my cost basis (the amount I originally paid).
Now, let’s fast forward to February 18, 2021. I decide to sell my bitcoin on this day, at the closing price of $51,679.80 U.S. dollars. Again, let’s round to $51,679.00. The fair market value (FMV) is $516,790.00 for 10 bitcoins.
By selling my hypothetical bitcoin at the FMV of $516,790.00, I have a long-term capital gain of $482,220.00. Because I acquired a long-term capital gain of over $450,850, I owe a 20% tax. That’s $96,444.00. I additionally owe a 3.8% tax for Medicare – $18,324 and some change. Finally, if I live in a state with state income tax, I will also owe that respective rate. Let’s say my state has a flat income tax rate of 5% – that equates to $24,111.00.
Now, calculating this together: I started with a capital gain of $481,530.00, but around $138,879.00 went to taxes. After taxes, I have actually earned $342,651.00 from my long-term investment. So, as with all investments, make sure you understand the exact amounts so you don’t end up spending more than you have.
Assembling Documentation for Your Tax Report
There are a few more factors to take into consideration. For example, if you received virtual currency as income from an employer, it must be included on Form W-2. If you received it as income as an independent contractor, it may be subject to self-employment tax.
While I’ve summarized a few key points, the IRS FAQ page overviews additional scenarios, such as if you “mined” cryptocurrency, received cryptocurrency as a bona fide gift, or gave cryptocurrency to a charitable organization. This page can be referenced if you are unsure of your specific situation.
If you have acquired and used cryptocurrency, it must be reported when you file taxes. Most capital gains and losses for your virtual currency will be reported on Form 8949. Ordinary income will be reported on Form 1040 U.S. Individual Tax Return, Form 1040-SS, Form 1040-NR, or Form 1040, Schedule 1, Additional Income and Adjustments to Income (IRS).
Recently, cryptocurrency has been at the forefront of the news once again. With cryptocurrency increasing in popularity (and with the tax season in full-swing), be sure to accurately document any taxable events that were initiated with cryptocurrency.
Dunham: World-Class Trust and Investment Firm
Documentation of virtual currency is just one of the many items you need to assemble as you prepare to file your taxes. While filing for tax season 2020 is already in full swing, it is never too early to begin preparing for the 2021 tax year.
Disclosure: This document is provided for informational purposes only by Dunham & Associates Investment Counsel, Inc. solely in its capacity as a Registered Investment Adviser and should not be construed as legal and/or tax advice. Dunham & Associates Investment Counsel, Inc. does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction. Subscribe to the Dunham Blog