While the IRS acknowledges that bitcoin and other cryptocurrencies can be used to pay for goods and services in many cases, and can be readily exchanged for U.S. currency, it treats it a bit differently than foreign currencies for tax purposes.
Specifically, the IRS classified bitcoin as property. This means it is treated the same as if you bought a piece of artwork and sold it for a profit, or if you sell a stock for more than you paid. If you bought, sold, spent, or even mined bitcoin in 2020, here's a primer on how it could affect your tax bill.
Capital gains tax 101
For this reason, profits that result from selling bitcoin will result in a capital gain (foreign currency gain or loss is a different concept). You can read our guide to 2020 capital gains taxes, but the key thing to know is that there are two kinds of capital gains:
- If you owned an asset for a year or less, a profitable sale will result in a short-term capital gain, and will be taxed just like ordinary income.
- If you owned an asset for more than a year, a profitable sale will result in a long-term capital gain, which has generally lower tax rates.
And while it isn't much of an issue right now, if you sell bitcoin for less than you paid for it, you will have a capital loss, which can be used to offset other capital gains and might even be able to reduce your other taxable income.
Did you spend bitcoin? It could get complicated
Here's where it can make your tax return really complicated. When it comes to bitcoin and other cryptocurrencies, you might find yourself owing taxes simply for spending bitcoin to pay for goods and services.
Because the IRS taxes bitcoin as property, not as a currency, spending it is considered to be a capital transaction. According to the IRS's guidance on the matter, "If the fair market value of property received in exchange for virtual currency exceeds the taxpayer's adjusted basis of the virtual currency, the taxpayer has taxable gain."
Here's what this means. Let's say that you bought $100 worth of bitcoin and its value rose to $300 over the next year. If you use your bitcoin to buy an airline ticket that would sell for $300, you have a $200 taxable gain on the purchase. Conversely, if you spend bitcoin that you paid more for, you could have a loss for tax purposes.
As you can probably imagine, if you use bitcoin to pay for goods and services regularly, this can get rather complicated. Especially if you bought bitcoin on various dates for different prices. Now, the IRS isn't likely to track you down and audit you if you buy a $2 soda with bitcoin you paid $1 for. But if you make any substantial purchases with appreciated bitcoin, be sure to keep track and report them.
What if you mined bitcoin?
If you mined bitcoin, you could also have a taxable gain. And this is even true if you haven't sold or spent any of the digital currency you mined.
Specifically, when you mine bitcoin, its fair value on the date you mine it is considered to be taxable income. For example, if you mine $50 worth of bitcoin today, you'll add that to your taxable income for the year. When you eventually sell or otherwise dispose of it, this is also the reference price to determine if you have a taxable gain or loss.
There are a lot of "what ifs"
Obviously, there are more possible situations involving bitcoin and other digital currencies than I can cover in a single article. For example, if you mine bitcoin as your primary business, do you also have to pay self-employment tax on the value of the mined cryptocurrency? What if you run a business and a customer pays you with bitcoin, which then grows in value?
The IRS has issued extensive virtual currency guidance that covers these questions and many other scenarios, so be sure to check it out if you need a specific answer. Better yet, if you have any complicated tax situation involving bitcoin and/or other cryptocurrencies, the best move is to consult an experienced tax professional who can make sure you're doing it right. Since bitcoin gained so much value in 2020, you can bet the IRS will be on the lookout for money they're owed.
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Matt Frankel, CFP, has no position in any cryptocurrencies mentioned. The Motley Fool has no position in any cryptocurrencies mentioned. The Motley Fool has a disclosure policy.