As bitcoin (BTC) approaches its all-time high, it's important to keep a few things in mind to stay out of IRS tax troubles. Here are the top six points you should remember:
1. Cashing out BTC is a taxable event: According to IRS Notice 2014-21, the IRS treats BTC as property. So, when you sell BTC into cash, it results in a taxable event. For example, if you bought 1 BTC for $10,000 a few years ago and sold it for $50,000 in 2024, you have a taxable gain of $40,000 ($50,000 - $10,000).
2. Converting BTC into other coins is also a taxable event: Many people mistakenly think that they only have to pay taxes if they receive cash after a trade. Unfortunately, this is not the case. For instance, if you bought 1 BTC for $10,000 a few years ago and when 1 BTC is trading at $50,000, you convert it into 25 Ethereum (ETH), you still have a taxable gain of $40,000 ($50,000 - $10,000), even if you didn't receive any cash in hand.
3. Different tax rates for short-term and long-term gains: There are two types of crypto gains – short-term and long-term. Short-term capital gains occur when you sell BTC or any other coin after holding it for less than 12 months. The tax rate for short-term gains can range from 10% to 37%, depending on your annual tax bracket. On the other hand, long-term capital gains occur when you sell BTC or any other coin after holding it for more than 12 months. Long-term gains are subject to a 0%, 15%, or 20% tax rate, depending on your overall taxable income. Generally, generating long-term capital gains is more tax advantageous due to the lower tax rates.
4. Set aside cash for taxes: When you have crypto gains without receiving any cash, it's essential to set aside money to cover the tax bill. In our previous example, when Sam traded 1 BTC into 25 ETH, resulting in a $40,000 capital gain, he would need to pay taxes on this gain in USD. It's prudent to set aside around 20% of the gain to cover the tax liability. In this case, Sam could set aside $8,000 ($40,000 * 20%) in cash to cover the related tax liability.
5. Use HIFO accounting method: Highest-in-First-out (HIFO) accounting method can help minimize your capital gains by selling the BTC with the highest cost basis first. You can use this method if you maintain meticulous records, as described by the IRS. However, manually managing these records across various coins and wallets can be burdensome. To ease the process, you can rely on reputable crypto tax software tools to manage your records and calculate capital gains using the tax advantageous HIFO accounting method.
6. Quarterly tax payment obligations: Large gains in cryptocurrencies may trigger federal and state quarterly tax payment obligations. The US operates on a pay-as-you-go tax system. This means you pay taxes as you earn income instead of waiting until the end of the year. If you make significant crypto gains, you may have to remit additional taxes to the IRS and your state government each quarter. Neglecting these 'estimated tax payments' can lead to penalties when filing your tax return at the end of the year. Generally, you should make estimated tax payments if you expect to owe $1,000 or more in taxes when you file your return.
In conclusion, as bitcoin reaches new heights, it's crucial to understand the tax implications associated with trading and cashing out cryptocurrencies. By staying informed and following the guidelines provided by the IRS, you can navigate the complexities of crypto taxation and ensure compliance with tax regulations. Always consult with a tax professional for personalized advice based on your specific situation.
