Understanding Bitcoin and Its Tax Implications

Bitcoin and other crypto coins are digital currencies that can be used worldwide and are not issued by any particular government or institution. If you pay taxes in Pennsylvania, it is critical to talk with an accountant about your bitcoin. Bitcoin was the first cryptocurrency invented, which began distribution in 2009, and is by far the most valuable and most traded. Growing very slowly at first, it began to take off in recent years, and on January 1, 2022, the value of a single Bitcoin was over $47,000. Of course, Bitcoin can be traded and used for purchasing goods and services in fractions of a coin. 

While Bitcoin uses terms that imply hard currency – such as coin, wallet, vault, ledger, mining for coins – there is no physical or tangible representation of Bitcoin, as we understand it. You cannot hold a Bitcoin in your hand as you can hold a dollar bill. The value of Bitcoin is based on supply and demand, and since there is currently a very high demand for it, the price has soared in recent years. In this sense, it is not unlike a high-risk stock.

Bitcoin and the IRS

Bitcoin is taxable, but the IRS was concerned that many taxpayers were failing to report their transactions. In 2019, over 10,000 taxpayers suspected of underreporting received a letter warning them that incorrect reporting could lead to penalties, interest, and possible criminal prosecution. 

Beginning with the 2020 tax season, the IRS moved to page 1 of the 1040 Form the question, “At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?” Therefore, it is critical to make it clear to your clients that they need to provide you with information about their crypto transactions, no matter how small. 

Tax implications

IRS Notice 2014-21 states: “For federal tax purposes, virtual currency is treated as property. General tax principles applicable to property transactions apply to transactions using virtual currency.”

Thus, if Bitcoin was held for more than a year before selling, that is to say, making any transaction in Bitcoin, it is considered long-term capital gains and is taxed accordingly. If it is held for one year or less, it will be taxed at the taxpayer’s normal income tax rate. Conversely, selling at a loss can offset taxes owed and can be carried over into future years. Generally, the “First In First Out” method is used for determining whether Bitcoin transactions are long-term or not.

However, sometimes Bitcoin is treated as income. Employers can pay employees in Bitcoin and it is handled as normal income. Additionally, miners, who verify transactions and are paid for their services in Bitcoin, will have to pay taxes on it in the year it is earned, essentially as business income. 

Depending on your client’s income level and amount of gains, Net Investment Income Tax may also be triggered. 

Learning more about Bitcoin

As a tax preparer, it’s important for you to be fully educated in the many aspects of Bitcoin and ongoing rulings from the IRS, such as the issue of hard forks and airdrops, which are somewhat like stock splits but can be performed in different ways. There are ongoing examinations regarding whether they should be treated as capital gains, dividends, gross income, “free money,” or even like-kind transfers. Questions regarding donating, gifting, and inheriting Bitcoin are also ongoing. 

Since cryptocurrency is a new and evolving industry that is experiencing a great deal of growth, keep your eyes and ears open to new rulings so you’re able to advise your clients and guide them through this exciting, evolving financial realm.