Cryptocurrency is, fundamentally, a type of virtual currency that utilizes strong cryptography to encrypt financial transactions and regulate currency production.
Since cryptocurrencies are developed using blockchain technology, there is no central body that governs them. Bitcoin happens to be the most popular cryptocurrency today. It can be stored in a digital wallet and accessed using a smartphone or computer
An Introduction to Bitcoin
Bitcoin is widely known as the first and most popular cryptocurrency to hit the market. It was designed and developed by a pseudonymous individual or a group of individuals under the name of Satoshi Nakamato.
Nakamoto’s real identity remains unknown to this day. There is no use of physical coins. Instead, balances are maintained on a public ledger.
Essential Characteristics of Bitcoin
It is vital to understand the fundamental characteristics of Bitcoin and get a better grip on this cryptocurrency before we discuss about Bitcoin tax.
Thanks to Bitcoin’s Peer to Peer (P2P) network and no intermediaries, Bitcoin transactions are irreversible. Be sure to verify your transaction before you confirm it.
No Need for Paperwork
You do not need any paperwork to carry out Bitcoin transactions. You do not need to have an ID card or a proof of address that regular banks would typically require you to submit before you open an account.
In this case, you only have to download a Bitcoin wallet program and generate your Bitcoin address.
Feasible, Cost-effective Transaction Method
The fact that it is a cost-effective transaction method is a significant point in Bitcoin’s favor. Information is sent and received between computers in the P2P network in the absence of intermediary bodies.
Given how there are no intermediaries in a Peer to Peer network, Bitcoin enables transactions to happen very quickly.
Going about Bitcoin Tax Reporting
As per the regulations set by the Internal Revenue Service (IRS), Bitcoin is to be treated as property and not as currency for tax. This also applies to the other cryptocurrencies like Litecoin, Ethereum, and so on.
Bitcoin is considered a form of property like gold, real estate, stocks, and so forth. In other words, you will need to report your capital gains and losses that are realized when you trade Bitcoin or other cryptocurrencies. A failure to do the same will leave you prone to tax fraud penalties by the IRS.
What are Capital Gains and Losses?
Before covering Bitcoin tax reporting, it is essential to understand capital gains and losses.
A rise in the value of your capital asset is known as a capital gain. You generally have to pay tax on capital gains. A capital loss, on the other hand, refers to a dip in the value of your capital asset. A capital loss reduces the taxable income on your tax return.
Calculating Bitcoin Taxes
Here’s how you get started with Bitcoin tax reporting.
Knowing what constitutes a Taxable Event
A taxable event refers to a situation where you incur a reporting liability on your cryptocurrency transactions. The following scenarios qualify for a taxable event:
- Trading your Bitcoin (or any other cryptocurrency) for fiat currency such as the US dollar
- Trading one cryptocurrency for another cryptocurrency is a taxable event
- Using your cryptocurrency for the purchase of goods or services is taxable
- Mining a cryptocurrency qualifies for a taxable event
The following scenarios do not qualify for a taxable event:
- Gifting a third-party cryptocurrency does not qualify as a taxable event.
- Transferring cryptocurrencies from wallet-to-wallet is not a taxable event.
- Using USD to buy cryptocurrency does not qualify as a taxable event. You only realize gains when you trade or sell your cryptocurrency.
Determine your Cost Basis
Your cost basis refers to the amount of money you invest in the property. As far as Bitcoin and other cryptocurrencies are concerned, it generally includes the buying price along with the additional costs that come with buying the Bitcoin. These extra costs generally include brokerage commissions from the exchanges from which you buy the cryptocurrency and transaction fees. Use the following formula to calculate your cost basis:
(Purchase Price of Crypto + Other fees) / Quantity of Holding = Cost Basis
Calculating your Capital Gains or Losses
You need to subtract your cost basis from the sale price or the Fair Market Value to calculate your capital gain or loss.
Fair Market Value – Cost Basis = Capital Gain or Loss
The Bitcoin Tax Reporting Process
You require two forms for Bitcoin tax reporting. These two forms are the 1040 Schedule D and the 8949 form. The Schedule D form allows you to report your capital gains on your personal property. This includes stocks, vehicles, and so on.
You can use form 8949 to list out each Bitcoin transaction you made during the year, and the capital gains realized on each trade. Then, sum these up and declare the total at the bottom for the 8949 form, and transfer this total to the 1040 Schedule D form.
Evading Bitcoin Tax Reporting
Given the intangible nature of cryptocurrencies, crypto traders seem to believe they can cheat the system and avoid the arduous process of Bitcoin tax reporting.
However, this is far from the truth. Recently, the IRS started to take strict action against traders who would avoid Bitcoin tax reporting. The IRS mailed more than 10,000 letters to crypto holders where they warned them of stiff penalties if they continued to avoid paying tax on crypto.