04-30-2025, 02:28 PM
#6: How does the IRS know about my gains?*
The IRS only knows what it is told. This means that it has no knowledge of your bitcoin transactions unless someone tells them. Here are four way that can happen (others may exist).
First, your bitcoin exchange or payment processor may report your transactions to the IRS. This would be done with a Form 1099, which you’ve probably encountered at one time or another in a different context. However, it does not appear that bitcoin transactions are currently subject to the 1099 reporting requirements (although that will probably change). Thus, unless they voluntarily file a 1099 against you, it is unlikely that the IRS will receive a report of your bitcoin transactions. Note that they would need your social security number to file a 1099 in your name.Edit: IRS Notice 2014-21 clarifies that "payment settlors" who convert bitcoin payments to cash for merchants will have to file 1099s. IF you are not a merchant, than this does not impact you.
Second, your bank or bitcoin exchange might file a Suspicious Activity Report ("SAR"). US banks and bitcoin exchanges are required to file SARs for wire transfers that are “suspicious” and larger than $5,000 ($2,000 in the case of bitcoin exchanges). The meaning of “suspicious” is very vague and highly discretionary. Out of an abundance of caution, many banks automatically treat all international transfer as “suspicious.” So, if you’ve sent or received a wire transfer of more than $5,000 to/from an international bitcoin exchange like Mt. Gox or BTC-e, you can be pretty sure that your bank has already filed a SAR against you (although they are prohibited from telling you if they did, so you'll never know for sure). The larger and/or more frequent you SAR filings, the more likely they will become a legitimate red flag and trigger an investigation. Although FinCEN is generally concerned with money laundering activities, the IRS does have access to FinCEN filings and it is common for IRS special agents to participate in FinCEN investigations.
Third, someone can rat you out to the IRS, which happens far more often than you might think. The simple fact is that people get jealous, and if they've heard that you've made lots of tax free money with bitcoin, they might get tempted to make sure justice is served. There's also that nice reward the IRS will pay them for snitching.
Fourth, you voluntarily and accurately report your gains on your tax return. That might sound ridiculous to some people given the inherent anonymity of bitcoin, but there are some very rich people in prison right now who used to think the same thing about their Swiss bank accounts. The fact is that penalties for failing to report income are significant. This includes the possibility of criminal prosecution. You can also add to this the additional penalties for failing to report foreign financial accounts (discussed below), which can be even more severe.
At the end of the day, you have a decision to make. You can comply with the law and pay taxes just like everyone else, which is admittedly unpleasant. Alternatively, you can violate the law and hope that you don't get caught. Maybe you will, maybe you won't. If you are caught, though, the amount of money you'll be forced to pay in penalties and interest will drastically exceed the amount you saved. That's not to mention the possibility of a felony criminal conviction and a prolonged stay at Club Fed. Personally, I have seen the havoc wreaked on people's lives by tax crimes and I would never want to be in their shoes. Neither should you.
TL; DR:Gains on bitcoins are taxable income. They become taxable when you sell bitcoins for cash or exchange them for goods or services. The IRS does not receive any direct information regarding your bitcoin transactions, but it has other ways of finding out. The monetary and criminal penalties for failing to report gains are not worth the taxes you'd save.
Topic 2: Recognition
#7: How do I calculate my gain or loss? * Gain or loss is calculated first on each bitcoin transaction, then on an aggregate basis by combining all your gains and losses to produce a net figure. Your tax preparation software will automatically perform these calculations, so the actual mechanics aren't really necessary for you to understand. However, you'll have to know the basics in order to enter the correct information into the software.
Basically, gain or loss is computed by taking the sales price of each bitcoin and subtracting its cost. The technical terms are “amount realized” and “basis.” Although simple in concept, determining amount realized and basis can be quite complex, as we’ll see below.
Edit: A good tool for calculating your gain or loss in bitcoin transactions is available for free atwww.bitcointaxes.info.
#8: What is my Basis?
Generally, basis is equal to cost. So, if you purchase 1 BTC for $500, then your basis is $500. You can also add to this amount any acquisition costs like broker commissions or wire transfer fees. So, let's assume a 1% fee and a $5 wire transfer fee. This would mean your basis is $500 + $5 + $5 = $510.00. If you later sell that bitcoin for $900, your gain would be [$900] - [$510] = [$390].
#9: How do I determine my basis in each bitcoin?*
If you’ve acquired bitcoins at different times and at different prices, determining basis can be quite complex. This is because bitcoins are fungible. Once a bitcoin is purchased, it becomes indistinguishable from the other bitcoins stored in the same wallet or account. In a subsequent sale or exchange, there is no way to trace the cost or acquisition date of the bitcoin being transferred out.
Contrary to what you might have heard, it is not acceptable to arbitrarily choose the bitcoin with the highest cost or most preferable tax impact. The IRS requires you to use a system with rules that will produce a reasonable and consistent result. The default system (and the one generally preferred by the IRS) is to assume that your bitcoins are sold in the order they were acquired. Thus, the first bitcoin you purchase is assumed to be first bitcoin you sell. This is called the FIFO method ("First in, First Out").
There are some other methods available, such as LIFO ("Last In, First Out") and Average Cost Basis, but it’s not clear if bitcoins are eligible for these alternatives. So, I would caution against using any system other than FIFO without guidance from a tax advisor or instructions from the IRS.
I'll note that it's theoretically possible to avoid this problem altogether if you keep each and every bitcoin purchase in separate wallets or accounts. This would allow you to trace the actual cost of each bitcoin you later sell or exchange, alleviating the need for the FIFO (or alternative) method.
Either way, determining cost will require some detailed record keeping. I will discuss record keeping in more detail below, but remember that the burden to prove basis is on you. The IRS will not give you the benefit of the doubt here. If you cannot prove the cost of each bitcoin, they will assume it was $0. Obviously you don't want that to happen, so keep good records of your bitcoin purchases.
#10: What if I mined my bitcoins, what is my basis then?
IRS Notice 2014-21 clarifies the treatment for bitcoin miners. Specifically, miners must recognize income for each bitcoin mined during the taxable year. The amount of income is equal to the market price of bitcoin on the day it is awarded on the blockchain. This also becomes the miner's basis in the bitcoin going forward and will be used to calculate gain/loss in the future when the bitcoin is sold.
For example, assume you mine 1 bitcoin in 2013. On the day it was mined, the market price of bitcoin was $1,000. You have $1,000 of taxable income in 2013. Going forward, your basis in the bitcoin is $1,000. If you later sell the bitcoin for $1,200, you have a taxable gain of $1,200 - $1,000 = $200. See below for the character of this gain.
You mining expenses, such as electricity, would not be included into basis. Instead, they would be deductible in the taxable year as an expense. Miners will need to determine if their mining activity rises to the level of a trade or business, which is a highly factual determination.
#11: What if I received my bitcoins as payment, what is my basis then?
If you sell goods or services and accept bitcoin as payment, your basis in those bitcoins is equal their fair market value at the time they were received. Generally, this is determined by reference to the average market price on that day. Thus, if you wrote a software program for someone and received 1 BTC as payment on November 1st, your basis in those bitcoins is equal to the average price of 1 BTC on that day.
The choice of which exchange to use for this purpose (e.g. Mt. Gox, Bitstamp, etc.) is up to you. Whichever exchange you choose, you should have a reasonable explanation for your choice. You should also stick with that choice when computing your gains in the future. Arbitrarily picking exchange prices that best suit your tax interests will not be acceptable to the IRS in a subsequent audit.
The IRS only knows what it is told. This means that it has no knowledge of your bitcoin transactions unless someone tells them. Here are four way that can happen (others may exist).
First, your bitcoin exchange or payment processor may report your transactions to the IRS. This would be done with a Form 1099, which you’ve probably encountered at one time or another in a different context. However, it does not appear that bitcoin transactions are currently subject to the 1099 reporting requirements (although that will probably change). Thus, unless they voluntarily file a 1099 against you, it is unlikely that the IRS will receive a report of your bitcoin transactions. Note that they would need your social security number to file a 1099 in your name.Edit: IRS Notice 2014-21 clarifies that "payment settlors" who convert bitcoin payments to cash for merchants will have to file 1099s. IF you are not a merchant, than this does not impact you.
Second, your bank or bitcoin exchange might file a Suspicious Activity Report ("SAR"). US banks and bitcoin exchanges are required to file SARs for wire transfers that are “suspicious” and larger than $5,000 ($2,000 in the case of bitcoin exchanges). The meaning of “suspicious” is very vague and highly discretionary. Out of an abundance of caution, many banks automatically treat all international transfer as “suspicious.” So, if you’ve sent or received a wire transfer of more than $5,000 to/from an international bitcoin exchange like Mt. Gox or BTC-e, you can be pretty sure that your bank has already filed a SAR against you (although they are prohibited from telling you if they did, so you'll never know for sure). The larger and/or more frequent you SAR filings, the more likely they will become a legitimate red flag and trigger an investigation. Although FinCEN is generally concerned with money laundering activities, the IRS does have access to FinCEN filings and it is common for IRS special agents to participate in FinCEN investigations.
Third, someone can rat you out to the IRS, which happens far more often than you might think. The simple fact is that people get jealous, and if they've heard that you've made lots of tax free money with bitcoin, they might get tempted to make sure justice is served. There's also that nice reward the IRS will pay them for snitching.
Fourth, you voluntarily and accurately report your gains on your tax return. That might sound ridiculous to some people given the inherent anonymity of bitcoin, but there are some very rich people in prison right now who used to think the same thing about their Swiss bank accounts. The fact is that penalties for failing to report income are significant. This includes the possibility of criminal prosecution. You can also add to this the additional penalties for failing to report foreign financial accounts (discussed below), which can be even more severe.
At the end of the day, you have a decision to make. You can comply with the law and pay taxes just like everyone else, which is admittedly unpleasant. Alternatively, you can violate the law and hope that you don't get caught. Maybe you will, maybe you won't. If you are caught, though, the amount of money you'll be forced to pay in penalties and interest will drastically exceed the amount you saved. That's not to mention the possibility of a felony criminal conviction and a prolonged stay at Club Fed. Personally, I have seen the havoc wreaked on people's lives by tax crimes and I would never want to be in their shoes. Neither should you.
TL; DR:Gains on bitcoins are taxable income. They become taxable when you sell bitcoins for cash or exchange them for goods or services. The IRS does not receive any direct information regarding your bitcoin transactions, but it has other ways of finding out. The monetary and criminal penalties for failing to report gains are not worth the taxes you'd save.
Topic 2: Recognition
#7: How do I calculate my gain or loss? * Gain or loss is calculated first on each bitcoin transaction, then on an aggregate basis by combining all your gains and losses to produce a net figure. Your tax preparation software will automatically perform these calculations, so the actual mechanics aren't really necessary for you to understand. However, you'll have to know the basics in order to enter the correct information into the software.
Basically, gain or loss is computed by taking the sales price of each bitcoin and subtracting its cost. The technical terms are “amount realized” and “basis.” Although simple in concept, determining amount realized and basis can be quite complex, as we’ll see below.
Edit: A good tool for calculating your gain or loss in bitcoin transactions is available for free atwww.bitcointaxes.info.
#8: What is my Basis?
Generally, basis is equal to cost. So, if you purchase 1 BTC for $500, then your basis is $500. You can also add to this amount any acquisition costs like broker commissions or wire transfer fees. So, let's assume a 1% fee and a $5 wire transfer fee. This would mean your basis is $500 + $5 + $5 = $510.00. If you later sell that bitcoin for $900, your gain would be [$900] - [$510] = [$390].
#9: How do I determine my basis in each bitcoin?*
If you’ve acquired bitcoins at different times and at different prices, determining basis can be quite complex. This is because bitcoins are fungible. Once a bitcoin is purchased, it becomes indistinguishable from the other bitcoins stored in the same wallet or account. In a subsequent sale or exchange, there is no way to trace the cost or acquisition date of the bitcoin being transferred out.
Contrary to what you might have heard, it is not acceptable to arbitrarily choose the bitcoin with the highest cost or most preferable tax impact. The IRS requires you to use a system with rules that will produce a reasonable and consistent result. The default system (and the one generally preferred by the IRS) is to assume that your bitcoins are sold in the order they were acquired. Thus, the first bitcoin you purchase is assumed to be first bitcoin you sell. This is called the FIFO method ("First in, First Out").
There are some other methods available, such as LIFO ("Last In, First Out") and Average Cost Basis, but it’s not clear if bitcoins are eligible for these alternatives. So, I would caution against using any system other than FIFO without guidance from a tax advisor or instructions from the IRS.
I'll note that it's theoretically possible to avoid this problem altogether if you keep each and every bitcoin purchase in separate wallets or accounts. This would allow you to trace the actual cost of each bitcoin you later sell or exchange, alleviating the need for the FIFO (or alternative) method.
Either way, determining cost will require some detailed record keeping. I will discuss record keeping in more detail below, but remember that the burden to prove basis is on you. The IRS will not give you the benefit of the doubt here. If you cannot prove the cost of each bitcoin, they will assume it was $0. Obviously you don't want that to happen, so keep good records of your bitcoin purchases.
#10: What if I mined my bitcoins, what is my basis then?
IRS Notice 2014-21 clarifies the treatment for bitcoin miners. Specifically, miners must recognize income for each bitcoin mined during the taxable year. The amount of income is equal to the market price of bitcoin on the day it is awarded on the blockchain. This also becomes the miner's basis in the bitcoin going forward and will be used to calculate gain/loss in the future when the bitcoin is sold.
For example, assume you mine 1 bitcoin in 2013. On the day it was mined, the market price of bitcoin was $1,000. You have $1,000 of taxable income in 2013. Going forward, your basis in the bitcoin is $1,000. If you later sell the bitcoin for $1,200, you have a taxable gain of $1,200 - $1,000 = $200. See below for the character of this gain.
You mining expenses, such as electricity, would not be included into basis. Instead, they would be deductible in the taxable year as an expense. Miners will need to determine if their mining activity rises to the level of a trade or business, which is a highly factual determination.
#11: What if I received my bitcoins as payment, what is my basis then?
If you sell goods or services and accept bitcoin as payment, your basis in those bitcoins is equal their fair market value at the time they were received. Generally, this is determined by reference to the average market price on that day. Thus, if you wrote a software program for someone and received 1 BTC as payment on November 1st, your basis in those bitcoins is equal to the average price of 1 BTC on that day.
The choice of which exchange to use for this purpose (e.g. Mt. Gox, Bitstamp, etc.) is up to you. Whichever exchange you choose, you should have a reasonable explanation for your choice. You should also stick with that choice when computing your gains in the future. Arbitrarily picking exchange prices that best suit your tax interests will not be acceptable to the IRS in a subsequent audit.