After the approval of the Bitcoin spot trading ETF, investors should also pay attention to the details of the taxation of these products by the US Internal Revenue Service (IRS). This article is sourced from an article titled “How to Tax Individual Bitcoin ETF Investments for US Residents” written by TaxDAO and compiled, translated, and written by Wu Blockchain.
Table of Contents:
What is a Bitcoin ETF?
How is a Bitcoin ETF taxed?
Key tax considerations for Bitcoin ETFs
As the cryptocurrency industry celebrates the long-awaited approval of the Bitcoin spot trading ETF, investors must understand how the IRS will tax these products.
An ETF is a financial instrument that allows investors to invest in a variety of assets and industries through a single share. A Bitcoin ETF allows investors to invest in Bitcoin without directly holding it.
The launch of an ETF involves multiple parties. In a Bitcoin ETF, Authorized Participants (APs), usually market makers or large banks, provide cash to the grantor trust established by sponsors such as Ark Invest or Blackrock. The trust then uses the provided cash to purchase Bitcoin and issues trust shares representing underlying Bitcoin to the AP. These ETF shares are subsequently sold to retail investors through public exchanges such as the New York Stock Exchange or Nasdaq.
ETF sponsors typically charge an annual fee (expense ratio) to cover their operational and management costs. As of December 31, 2022, the industry average expense ratio is 0.47%. Lastly, regulatory participants, namely the Securities and Exchange Commission (SEC), must approve the sponsor’s application before the ETF can be traded.
Futures-based Bitcoin (or any other cryptocurrency) ETFs track the price of Bitcoin through futures contracts. Since October 2021, several futures-based Bitcoin ETFs have been approved for trading, such as ProShares Bitcoin Strategy ETF (BITO), ProShares Short Bitcoin ETF (BITI), VanEck Bitcoin Strategy ETF (XBTF), etc. BITO, as the market leader, manages $2 billion in assets.
Taxation of ETFs begins with capital gains assessment but goes beyond that.
If you sell your Bitcoin ETF assets within one year of holding them, the resulting short-term capital gains will be subject to ordinary income tax. The tax rate may range from 10% to 37% depending on your overall taxable income and filing status.
If you sell your ETF assets after holding them for more than 12 months, the resulting long-term capital gains will be subject to capital gains tax. The tax rate may be 0%, 15%, or 20%, depending on your overall taxable income and filing status.
Additionally, if your income exceeds certain thresholds, you may be subject to an additional 3.8% tax in addition to the aforementioned capital gains tax.
But this is not the only way capital gains tax is assessed. Bitcoin ETFs spend a small portion of Bitcoin throughout the year to pay management fees. These transactions result in capital gains or losses due to the difference between the cost basis of the spent Bitcoin and its market value at the time of expenditure. For example, if a fund sells Bitcoin worth $40,000 to pay for management fees, the gains will be taxed proportionally based on each investor’s holdings in the fund.
Prior to the passage of the Tax Cuts and Jobs Act in 2018, investors could deduct their proportionate share of fund expenses as miscellaneous itemized deductions on Schedule A. Unfortunately, due to limitations introduced by the act, these expenses are no longer deductible and will become deductible again after December 31, 2025.
Compared to spot ETFs, the tax implications for futures-based Bitcoin ETFs (such as BITO) may be slightly different for holders. The specific details depend on the structure of these funds, particularly whether they are exposed to regulated or unregulated (as defined in IRC§1256) futures contracts.
If a fund holds regulated futures contracts (which are typically traded on dominant platforms like the Chicago Mercantile Exchange for Bitcoin futures), then, according to IRC§1256, 60% of the gains are treated as long-term capital gains and 40% as short-term capital gains, regardless of the holding period.
If a fund is exposed to positions in unregulated contracts, the gains will be subject to normal capital gains rules similar to stocks. Please note that the taxation of futures contracts can be highly complex, depending on the facts and circumstances of the contracts, as well as certain tax elections made by the fund and you. These factors will have a significant impact on when and how much tax is paid by the taxpayer.
Additionally, if you trade in cryptocurrency futures ETFs, fund expenses are typically paid in cash, which does not bring about the same capital gains or basis adjustment as spot ETFs.
ETF holders are required to file two types of tax compliance reports at the end of the year, namely Form 1099-B and Trust Tax Information Declaration, to fulfill their tax obligations.
Brokers may issue Form 1099-B to report the income and losses resulting from the disposition of ETF units. The form will report the cost basis, sales price, and resulting gains or losses of the ETF units. (Beginning with the 2025 tax year, this information may be reported on a new form, Form 1099-DA, dedicated to digital asset transactions, according to proposed broker regulations).
Simultaneously, the Trust Tax Information Declaration will display the amount of Bitcoin spent throughout the year for paying management fees. Paying fund expenses in Bitcoin can result in capital gains (or losses). The declaration will explain how to calculate the proportionate shares of capital gains or losses generated from these transactions for each investor.
You must refer to the Trust Tax Information Declaration to manually calculate this information, as it will not be reported on Form 1099-B. These declarations are unique to ETFs established as trusts. Most investors may not be familiar with these declarations.
Finally, in the year of selling the ETF, the basis reported on Form 1099-B needs to be adjusted with the information reported in the Trust Tax Information Declaration to arrive at the correct gains or losses. This can make tax compliance cumbersome for ordinary taxpayers. That’s why it is important to continue monitoring the progress of the next spot BTC ETF approval.
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