So far 2018 has been a relatively calm year for bitcoin and most cryptocurrencies. This is a far cry from 2017 where the price of bitcoin skyrocketed over 1300%. The enormous increase in price of bitcoin has caused significant tax headaches for many cryptocurrency investors.
Even though bitcoin is labeled as a “cryptocurrency”, from a federal income tax standpoint, bitcoins and other cryptocurrency are not considered a “currency.” On March 25, 2014, the IRS issued Notice 2014-21, which for the first time set forth the IRS position on the taxation of virtual currencies, such as bitcoins. According to the IRS Notice, “Virtual currency is treated as property for U.S. federal tax purposes.” The Notice further stated “General tax principles that apply to property transactions apply to transactions using virtual currency.” In other words, the IRS is treating the income or gains from the sale of a virtual currency, such as bitcoins, as a capital asset, subject to either short-term (ordinary income tax rates) or long term capital gains tax rates, if the asset is held greater than twelve months (15% or 20% tax rates based on income). By treating bitcoins and other virtual currencies as property and not currency, the IRS is imposing extensive record-keeping rules—and significant taxes—on its use.
Whereas, if bitcoin investors used a Roth IRA to make the investment, they would not be subject to any tax on the gains. Imagine if bitcoin or Ripple investors in 2017 were able to shelter almost 1300% of gains using a self-directed Roth IRA.
With a Roth IRA, contributions are after-tax, however, so long as the Roth IRA has been opened at least 5 years and you are over the age of 59 1/2, all Roth IRA distributions will be tax-free.
The self-directed IRA or Roth IRA is the most popular way a retirement account holder can use retirement funds to by cryptocurrency, such as bitcoin. The primary advantage of using a self-directed IRA LLC to make bitcoin IRA investments is that all income and gains associated with the IRA investment grow tax-deferred or tax-free in the case of a Roth IRA.
Below is a step-by-step breakdown of how to use a self-directed IRA to buy cryptocurrency, such as bitcoin:
- Establish self-directed IRA LLC with IRA Financial Trust & Northern Trust
- Your IRA cash/assets can be rolled over to IRA Financial Trust tax-free
- You as manager of the LLC will open a bank account for the LLC at any local bank. IRA Financial will draft LLC Operating Agreement identifying you as manager of the LLC and the IRA as the sole member
- At your direction, the bitcoin IRA custodian will invest the IRA assets to the LLC tax-free in exchange for 100% interest in the LLC
- The LLC will be owned 100% by the IRA. Since the LLC is owned 100% by an IRA, it will be treated as a disregarded entity for tax purposes. No Federal income tax return is required to be filed and all income and gains will flow back to the IRA without tax.
- The LLC will open an account at any cryptocurrency exchange, such as Coinbase. You as manager of the LLC will have total control over the cryptocurrency exchange account.
The IRS tax treatment of cryptocurrency has created a favorable tax environment for retirement account investors. Using a self-directed Roth IRA is the most tax efficient way to buy bitcoin.
Adam Bergman is the founder of the IRA Financial Group & IRA Financial Trust Company. For more information on this topic please call 800-472-0646.