Big Gains, Big Tax Headaches
Were you tempted in 2017 by cryptocurrencies promising huge financial gains? If you did make a Bitcoin purchase, you may have done very well. The value of Bitcoin gained more than 1,200% over the year.
Your gains pose a vexing question. How are you supposed to pay taxes on your Bitcoin earnings? In large part, that depends on what you do with them.
The IRS gave limited direction in a 2014 guideline that classified cryptocurrencies as property, subjecting them to capital gains taxes instead of lumping them into ordinary income. Unfortunately, in practice there is no solid dividing line on their use. The tax rules become correspondingly complex.
There's a reason it's called a cryptocurrency. A significant number of businesses and retailers accept Bitcoin for payment, including large companies such as Microsoft, Expedia, and Subway. You can't normally use property in retail purchases – imagine paying for your foot-long meatball sub with a share of Apple stock. (What would you receive in change?)
Property, Currency, or Both?
Do you consider cryptocurrencies a form of long-term investment like stocks, a true currency, or something in-between? The further you get away from the stock analogy, the messier your taxes will be.
If you only use Bitcoin as an investment, taxation is fairly straightforward. The gains from the sale of a cryptocurrency are taxed at capital gains rates if the cryptocurrency was held for more than one year. If they were held for less than one year, the gains are taxed as ordinary income according to the correct individual tax bracket. If you lose money on the exchange, you can write off losses following the standard rules on capital losses.
However, if you use Bitcoin to purchase goods and services, the taxation on that Bitcoin must be treated as an individual sale of that Bitcoin (true for all cryptocurrencies). Let's assume the Bitcoin you used to buy that meatball sub has twice the value of the original purchase price of that Bitcoin. You now owe taxes on the 100% gain in value of the Bitcoin that you just cashed in. On the bright side, if your Bitcoin dropped in value, you have a tax loss to write off.
Multiply this complexity over hundreds of ordinary daily transactions throughout the year, and it becomes very difficult to accurately assess the cryptocurrency taxes that you owe.
If part of your cryptocurrency income comes from an employer or from the direct "mining" of Bitcoins, it will be treated as regular income – whether or not there is an employer's W-2 form involved to verify the income. If you are self-employed, you are also responsible for the self-employment tax on that income. Income will be based on the dollar value at the time of receipt/mining.
Clear as mud, isn't it? We haven't even gotten into subjects such as foreign exchanges using cryptocurrency, or the fact that many cryptocurrency exchanges have no available records for the government to examine. It's hard to tell if the money totals don't add up when there are sources that you can't reach.
The Government Will Catch Up - Eventually
According to Tom Lee, a Wall Street strategist with Fundstrat Global Advisors, the collective cryptocurrency market gained $590 billion in total value last year and estimated that $187 billion of that growth is US-based.Lee calculates 2017 cryptocurrency taxes owed by US taxpayers at around $25 billion.
Meanwhile, from 2013 to 2015, the number of people recording cryptocurrency exchanges on their taxes varied between 800 and 900 taxpayers. Perhaps most people are holding onto cryptocurrencies as an investment – but that's highly unlikely.
The IRS agrees. Late last year, the agency won a court battle to subpoena records from the cryptocurrency transaction company Coinbase in order to determine taxes owed on cryptocurrency transactions between 2013 and 2015. Even with negotiated exclusions, the action could cover up to 14,000 Coinbase users and 8.9 million transactions. It's highly likely that there will be some collection of cryptocurrency back-taxes soon, with a focus on the largest dollar-equivalent volumes.
The way to simplify taxes on cryptocurrencies is to treat them strictly like stocks. Keep meticulous records on purchases and sales – both for timing and valuation at the time of purchase/sale, including exchanges of one cryptocurrency for another.
Stick to that dividing line, and you have a relatively straightforward calculation of your profit/loss and the subsequent tax effects.
If you start to use Bitcoin for retail/online purchases for goods and services, you open the door to a recordkeeping nightmare. However, if you've invested in Bitcoin or other cryptocurrencies in any significant way, you're a risk-taker by definition. Which odds are worse – the chances of you correctly logging and assessing all your cryptocurrency purchases, or the odds that the IRS will catch you, given the current level of understaffing and the lack of direction?
Only you can answer that question and decide whether you intend to do the right thing to the best of your ability (our recommendation) or lay low.
Consider this as you decide – uncollected taxes on cryptocurrency are a huge pool of potential income for governments. How long do you expect them to leave that pool alone, and how far back in time do you think legislators and regulators will go to collect back taxes?
This article was provided by our partners at moneytips.com.
To Read More From MoneyTips: