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” 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 long-awaited Bitcoin spot trading ETF has been approved, investors must understand how the IRS will tax these products.
An ETF is a financial instrument that allows investors to invest in various 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), typically 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 the underlying Bitcoin to APs. These ETF shares are then 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 trade.
Futures-based Bitcoin (or any other cryptocurrency) ETFs track the price of Bitcoin through futures contracts. Several futures-based Bitcoin ETFs have been approved for trading since October 2021, such as the 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 starts 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.
In addition to the above capital gains tax, if your income exceeds certain thresholds, you may also be subject to a 3.8% tax.
However, 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 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 the 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 restrictions introduced by the act, these expenses are no longer deductible and will be deductible again after December 31, 2025.
Compared to spot ETFs, futures-based Bitcoin ETFs (such as BITO) may have slightly different tax implications 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 the fund holds regulated futures contracts (which are typically traded on the dominant platform for Bitcoin futures, the Chicago Mercantile Exchange), then, according to IRC§1256, 60% of the gains are treated as long-term capital gains, and 40% of the gains are treated as short-term capital gains, regardless of the holding period.
If the fund is exposed to positions in unregulated contracts, the gains will be subject to normal capital gain rules similar to stocks. Please note that the taxation of futures contracts can be very complex and depends on the facts and circumstances of the contracts as well as certain tax elections made by the fund and you as the taxpayer. These factors can have a significant impact on when and how much tax you owe.
Additionally, if you trade in cryptocurrency futures ETFs, fund expenses are typically paid in cash, which does not result in the same capital gains or basis adjustments 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 statements, to fulfill their tax obligations.
Brokers may issue Form 1099-B to report the income and losses 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. (Starting from the 2025 tax year, this information may be reported on a new Form 1099-DA dedicated to digital asset transactions, according to proposed broker regulations).
At the same time, trust tax information statements will show the amount of Bitcoin spent throughout the year to pay management fees. Paying fund fees with Bitcoin may result in capital gains or losses. The statement will explain how to calculate the proportional share of capital gains or losses generated from these transactions for each investor.
You must refer to the trust tax information statements to manually calculate this information as it will not be reported on Form 1099-B. These statements are specific to ETFs structured as trusts. Most investors may not be familiar with these statements.
Finally, in the year you sell the ETF, you will need to adjust the basis reported on Form 1099-B using the information reported in the trust tax information statements to arrive at the correct gains or losses. This can make tax compliance cumbersome for the average taxpayer. That’s why it is important to continue monitoring the progress of the next spot BTC ETF approval.
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