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 Personal Bitcoin ETF Investments for US Residents” written by TaxDAO, compiled, translated, and written by Wu Shuo 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.
ETFs are financial instruments that allow investors to invest in various assets and industries through a single share. Bitcoin ETFs allow investors to invest in Bitcoin without directly holding it.
The launch of an ETF involves multiple parties. In the case of a Bitcoin ETF, the 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 APs. 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. Several futures-based Bitcoin ETFs, such as ProShares Bitcoin Strategy ETF (BITO), ProShares Short Bitcoin ETF (BITI), VanEck Bitcoin Strategy ETF (XBTF), have been approved for trading since October 2021. BITO, as the market leader, manages $2 billion in assets.
Taxation of ETFs starts with the assessment of capital gains but doesn’t end there.
If you sell your Bitcoin ETF assets within a 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 the 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.
In addition to the above capital gains tax, if your income exceeds certain thresholds, you may also be subject to a 3.8% tax.
But that’s 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 spending. For example, if a fund sells Bitcoin worth $40,000 to pay management fees, the resulting gains will be taxed proportionally based on each investor’s holdings in that fund.
Before 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 be deductible again after December 31, 2025.
Compared to spot ETFs, the tax impact on holders of futures-based Bitcoin ETFs (such as BITO) may be slightly different. The specific details depend on the structure of these funds, particularly whether they are exposed to regulated or unregulated (governed under IRC§1256) futures contracts.
If the funds hold regulated futures contracts (typically traded on the dominant platform for Bitcoin futures, the Chicago Mercantile Exchange), then according to IRC§1256, 60% of the gains, regardless of the holding period, are considered long-term capital gains, and 40% are considered short-term capital gains.
If the funds are 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 very complex, depending on the facts and circumstances of the contracts, as well as certain tax choices made by the funds and you as an investor. These factors can have a significant impact on when and how much tax is paid by the taxpayer.
Additionally, if you trade in a futures-based ETF, the fund expenses are typically paid in cash and do not result in the same capital gains or basis adjustments as spot ETFs.
ETF holders are required to report two types of tax compliance documents at the end of the year, namely the 1099-B form and the trust tax information declaration, to fulfill their tax obligations.
Brokers may issue 1099-B forms to report the income and loss generated from the disposal of ETF units. The form will report the cost basis, sale price, and resulting gains or losses of the ETF units. (According to proposed broker regulations, starting from the 2025 tax year, this information may be reported on a new form 1099-DA specifically for digital asset transactions.)
Meanwhile, the trust tax information declaration will display the amount of Bitcoin spent throughout the year to pay management fees. Using Bitcoin to pay fund expenses may result in capital gains (or losses). The declaration will explain how to calculate the proportional allocation of capital gains or losses generated from these transactions based on each investor’s holdings.
You will need to refer to the trust tax information declaration to manually calculate this information as it will not be reported on the 1099-B form. These declarations are unique to ETFs structured as trusts. Most investors may not be familiar with these declarations.
Finally, in the year you sell the ETF, you will need to adjust the basis reported on the 1099-B form using 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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