There are six types of people when it comes to Bitcoin and other cryptocurrencies:
- Those who have only first heard about it within the past few months or so and are still somewhat learning about it
- Those who still have not heard anything about it and have no clue what it is (if this is you, get out from under your rock and check out how the now-famous cryptocurrency has SKYROCKETED in 2017, especially in Q4)
- Those who are completely disinterested
- The investor
- The “trader”
- The “miner”
If you fall into categories 1-3, this blog may not be for you, unless you plan to become a trader or investor in the future.
If you are number 4, 5 or 6, proceed with caution.
Extremely Short and Vague Definition of Cryptocurrencies
Cryptocurrencies, like Bitcoin, are digital “currencies” that trade like stocks and other currencies (meaning people can buy and sell them on trading platforms like Coinbase) and can also be used to purchase goods and services, like actual money.
I warned you – extremely short and vague.
There is a lot more to it, but that’s all you’re getting from me since that is not the intended direction of the post…and because that’s pretty much the extent of my expertise in cryptocurrencies.
What I do know for sure, though, is how they could pull the sneak attack on your wallet come tax time.
The IRS’s Stance on Cryptocurrencies
Although mainstream media is labeling Bitcoin, Ethereum, Litecoin, and other digital “coins” as actual, virtual currencies, the IRS says otherwise. As far as Uncle Sam is concerned, cryptocurrencies are considered “property”.
What does that mean?
It means when you buy, sell, and trade cryptocurrencies, you’re really buying, selling, and trading goods, not virtual money.
More specifically, what does that mean for you?
If you’re an investor in cryptocurrencies, it’s likely you’ve made some money since the trend and market value have been continuously and exponentially on the rise. If you were an early investor, I tip my cap to you.
If you’re strictly investing in cryptocurrencies, the tax implications are pretty straightforward; sales of cryptocurrencies are taxed just like sales of stock: long-term holdings (one year or more) are taxed at preferential capital gains tax rates and short-term holdings (less than one year) are taxed at ordinary tax rates.
No more, no less.
The “trader” uses cryptocurrencies as actual currencies; they are traded for goods and services.
This causes a major tax problem…
Since the IRS categorizes cryptocurrency as property, using them to pay for goods and services is actually treated as two separate transactions:
- Sale of the cryptocurrency
- Purchase of the goods or services with the proceeds from the sale
That’s right… Each time you buy something with Bitcoin, Litecoin, etc., you will be taxed on the technical “sale” that occurs (#1 above) at the same rates described in the previous section.
On the flip side, if you receive Bitcoins or other cryptocurrencies in exchange for goods or services, you must include in gross income the fair market value of the virtual currency.
At the risk of botching the explanation of what a miner is, check out this excerpt straight from Bitcoin’s FAQ page:
New bitcoins are generated by a competitive and decentralized process called “mining”. This process involves that individuals are rewarded by the network for their services. Bitcoin miners are processing transactions and securing the network using specialized hardware and are collecting new bitcoins in exchange.
Miners aren’t as common as they were a few years ago given the computer power needed to efficiently and effectively mine cryptocurrencies today. But for any independent miners still out there, the IRS will certainly come knocking.
Being “rewarded” with Bitcoins or other cryptocurrencies is great, but it is taxable income. And to pour salt in the wound, it’s subject to self-employment tax, as well.
My Two Bit-cents
In my humble opinion (for whatever that’s worth), the drastic upward trend of Bitcoin is unsustainable. This is a bubble and it will burst. That does not mean it may not be here to stay, but the value will eventually decrease.
If you buy goods or services with cryptocurrencies, it may be a smart idea to stick to real money; last I checked, it’s not a taxable event when you buy something at the store with cash or credit card. If you bought the same exact thing at the same exact store with a cryptocurrency, you’d be creating a taxable event for yourself.
If you were an early investor, it may be wise to sell your holdings* and run off into the sunset with your profit in the form of money you can actually hold, but just make sure you are aware of the tax implications. If you plan to hold your investment for the long-term, call me when the bubble bursts and I’ll help you deduct your losses on your tax return.
*This is not investment advice and should not be taken as such.
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Nick Aiola is a CPA located in New York, NY. Nick provides the highest quality of tax and accounting services to a wide range of clients, including individuals, businesses, and fiduciary entities.
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