If you purchase Bitcoin and then sell it at a profit, you will be obliged to pay capital-gains levies, regardless of whether you convert the Bitcoin to dollars or alternate cryptocurrencies. The same applies if you obtain Bitcoin, its value rises, and then you trade it for commodities or amenities.
The IRS has provided guidance on cryptocurrency tax issues in two separate instances: IRS Revenue Ruling 2014-21 and 2019-24. In 2014, the IRS made a crucial determination that cryptocurrency is considered property instead of currency for federal tax purposes. As a result, profits earned from crypto-trading are subject to tax regulations similar to those governing stock-trading profits, given that both assets are regarded as property. Although treating crypto gains like stock may appear simple, the rules are less clear when it comes to Bitcoin and other forms of cryptocurrency. This is because crypto can be bought with dollars, its value can fluctuate and it can be exchanged for goods and services, or even cash at a Bitcoin ATM. These scenarios are not typical in stock trading, which adds to the complexity of cryptocurrency taxation rules.
Trading of crypto and short-term vs. long-term gains
Similar to managing your personal stock portfolio, you must monitor the value of the cryptocurrency you purchase and keep track of its value when sold or exchanged. Suppose you bought Bitcoin for $30,000 and sold it for $50,000. In that case, your profit would be $20,000, which is subject to either short-term or long-term capital gains taxes, depending on how long you held the Bitcoin. If you held your Bitcoin for over a year, you can benefit from the preferred long-term capital gains tax rates of 0-20%. Generally, low- to middle-income earners (typically less than $40,000 for singles, $80,000 for married couples) do not have to pay long-term capital gains tax, while mid- to high-income earners (usually income up to $441,000 for singles, $496,000 for married couples) typically pay a 15% tax rate. Meanwhile, high-income earners (usually those with incomes exceeding $441,000 for singles, $496,000 for married couples) pay a 20% tax rate.
Short-term capital-gains rates, ranging from 0-37%, based on your modified, adjusted gross income, apply if you possessed the Bitcoin or any other cryptocurrency for a period of one year or less.
Exchanging one crypto for another
Whenever one cryptocurrency is exchanged for another, it results in a taxable profit. To illustrate this, if you had purchased Bitcoin for $50,000 and subsequently swapped it for Ethereum valued at $70,000 a month later, you would have taxable earnings of $20,000. This applies regardless of whether the Bitcoin was held for a minute and traded for another cryptocurrency or held for several years.
Using crypto for goods or services
The increase in value of cryptocurrency from its purchase until it is exchanged for goods or services is taxed. This means that if you were to buy a Tesla with $100,000 worth of Bitcoin, you would need to keep track of when the Bitcoin was acquired and pay taxes on the increase. In this example, since the Bitcoin was purchased at $40,000, the gain when exchanged for the Tesla would be $60,000. If the Bitcoin was held for over a year, the tax would be at long-term capital gain rates, which are preferred. Conversely, if the Bitcoin was held for a year or under, the $60,000 gain would be taxed at short-term capital gains rates.
Crypto losses
If you purchase Bitcoin or other cryptocurrencies and then sell them for a lower price, you are eligible for a tax deduction for the loss. Losses can occur when exchanging cryptocurrency for other crypto assets or services at a loss. Crypto losses from one trade or exchange can be used to reduce the tax on other cryptocurrency profits. Short-term crypto losses can reduce short-term crypto gains, and long-term crypto losses can reduce long-term crypto gains. Crypto losses can possibly be used to reduce the tax on gains from stocks or mutual funds as well. If crypto losses exceed gains in other investments, up to $3,000 of the loss can be used to reduce other income like wages or self-employment income. Losses that cannot be fully used can be carried forward to future years and used to offset future crypto or stock-trading gains.
Crypto forks and airdrops
2019 saw the release of IRS guidance that shed light on two specific occurrences that may arise on a crypto blockchain. The first of these is known as a fork, which can take on various forms. As far as tax implications go, individuals who receive new coins resulting from a hard fork are required to pay taxes on these coins as ordinary income. Additionally, the IRS clarified that an airdrop of new coins to current cryptocurrency owners will also necessitate taxes on the recipient’s end at typical income-tax rates. Airdrops are generally given as promotional gestures and involve free distributions of coins or tokens to holders of existing cryptocurrencies.
Crypto mining and staking is ordinary income taxed at regular rates
Income generated from cryptocurrency mining and staking is considered ordinary income for tax purposes. These services involve computers providing support to a cryptocurrency blockchain network, with owners of these computers receiving cryptocurrency as compensation for their contribution. If an individual owned computers that provided mining or staking services, they would receive crypto in exchange for their services and be obligated to pay taxes on it to the IRS. This payment would be treated as taxable income, equivalent to receiving payment in dollars for performing the same services.
When you receive crypto, it is necessary to use its received value for tax-reporting purposes. If the received crypto’s value increases over time and is later sold or exchanged, you will be required to pay capital-gains tax on the increase in value. For example, imagine you received $1,000 worth of Bitcoin for providing crypto-mining services, and its value increased over three months, allowing you to sell it for $1,500. The initial $1,000 will be taxable as ordinary income and subject to regular tax rates of 0-37%. The remaining $500 profit earned from selling Bitcoin will be considered capital-gain income.
Record keeping and reporting is required
Form 8949 is necessary for reporting cryptocurrency gains and losses, as dictated by the IRS. It must be filed alongside your personal 1040 tax return. The leading crypto providers in America such as Coinbase, Gemini, Kraken, Cash App, PayPal, and Binance.us submit cryptocurrency transactions and trades to the IRS. Despite whether or not the exchange you utilized reports to the IRS, you are still required to report.
Using a company based outside of the U.S. does not exempt you from being taxed, so it’s important to tread carefully since this may call for more foreign asset reporting duties to the IRS.
Can You Hold Cryptocurrency in a Roth IRA?
It is feasible to have cryptocurrency in your Roth IRA account, but you must create an account on a specialized platform that provides this service.
Opting for a Roth IRA over a typical brokerage presents a benefit in the form of tax reductions since profits generated from increased investment values are exempt from capital gains taxes. While high-risk investments carry potential rewards, there is also a possibility of substantial losses. As a result, the tax savings might be noteworthy.
Even though custodians, who are the main providers of Roth IRA accounts, usually don’t facilitate direct investment in cryptocurrency, they frequently feature other investments related to cryptocurrency, such as coin trusts, futures, and stocks that have a connection to crypto.
Pros
There is a possibility of achieving significant profits without being subjected to taxes on them.
It may provide a means of enhancing the diversity of your investment portfolio.
Cons
Working with a small and relatively new custodian is likely necessary in order to have direct ownership.
Your holdings may be significantly reduced by fees. When investing in crypto IRAs, anticipate transaction fees of approximately 1% to 2% for every buy or sell; however, major custodians typically do not impose trading fees.
A financial planner may lack the necessary expertise to provide guidance on cryptocurrency.
Cryptocurrencies and Roth IRAs
To begin with, let’s cover some fundamental aspects of Roth IRAs and the guidelines set forth by the IRS:
By contributing after-tax dollars to a Roth IRA, you can invest in your retirement savings without being taxed on any investment earnings. However, any early withdrawals will result in penalties.
Rules set by the Internal Revenue Service dictate how such accounts operate and determine the permissible investment types. Included in the non-permissible investments are artworks and coin collections, but the allowance exists for investment in virtual currencies.
It is not possible to transfer pre-owned cryptocurrency into a Roth IRA; therefore, any additions to your account must be made through cash.
Investments are not subject to review, approval or endorsement by the IRS. The Commodity Futures Trading Commission, the regulatory authority for derivative markets in the US, has cautioned investors to be careful of sales pitches that promote virtual currency retirement accounts as “IRS approved” or “IRA approved.”
Owning cryptocurrency directly: What you should know
Major platforms don’t offer this option
It’s crucial to differentiate between the permissible options in Roth IRAs and the offerings of different custodians.
Although IRS regulations permit the possession of cryptocurrency in a Roth IRA, it is not mandatory for custodians to provide their clients with this choice. The option is not available from a number of well-known custodians, such as Vanguard, Charles Schwab, and TD Ameritrade.
Nonetheless, some custodians permit the storage of cryptocurrency in a Roth IRA such as Bitcoin IRA, Bit IRA and iTrustCapital. These companies specialize mainly in investing in cryptocurrencies; therefore, you won’t have access to a selection of stocks, mutual funds, ETFs, or any other investment categories found in traditional financial institutions.
Transaction fees apply
The costs of purchasing cryptocurrency may be substantial, and the lack of transparency is a concern when compared to traditional investment companies. Additionally, atypical charges such as launch fees may occur, which are not frequently seen among traditional IRA trustees.
Crypto platforms typically impose a transaction fee ranging from 1% to 2%. To put this into perspective, if you were to purchase $1,000 worth of crypto and subsequently sell it for $2,000, the transaction fee would amount to $30 to $60.
Transaction fees are not typically charged by major custodians. Investment funds like mutual funds or exchange-traded funds do come with expense ratios, but finding low-cost alternatives is commonplace. Consider buying an index fund with a 0.02% expense ratio and a value increase of $100 per year for 10 years with an initial investment of $1,000. The total fees accumulated over the 10-year period would only amount to $29.
You might need a separate IRA for traditional investments
While you may view cryptocurrency as a part of a varied investment portfolio including conventional investments, crypto IRAs usually don’t permit holding traditional investments, leaving you with a dilemma of holding both.
To have multiple Roth IRA accounts, opening them with two or more custodians is a viable choice. While there is a cap on the new funds that can be added to your owned Roth IRA accounts annually, the amount of accounts you can open is unrestricted. To illustrate, you may create a Roth IRA for typical investments and input $1,000, then establish a second account with a different company that handles cryptocurrency and input $500.
One alternative is to transfer some of the funds from your existing Roth IRA account into a new account that focuses solely on cryptocurrency.
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