How The IRS Will Tax Bitcoin ETFs

Overview

As the cryptocurrency industry revels in the long-awaited approval of bitcoin spot exchange-traded funds (ETF), investors must understand how the IRS will tax these products.

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Key Background

ETFs are financial instruments that allow investors to gain exposure to various assets and sectors with a single share. A bitcoin ETF allows investors to invest in bitcoin without directly holding the cryptocurrency.

There are several parties involved in launching an ETF. In the context of the bitcoin ETF, an authorized participant (AP), typically a market maker or a large bank, contributes cash to a grantor trust set up by sponsors like Ark Invest or Blackrock. The trust then purchases bitcoin using the contributed cash and issues shares in the trust to the AP representing the underlying bitcoin. These ETF shares are then sold to retail investors through public exchanges like 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%. Last but not least, the regulatory participant, the Securities and Exchange Commission (SEC), has to approve the sponsor application before the ETF is available to be traded.

Futures bitcoin (or any other cryptocurrency) ETFs track the bitcoin prices through future contracts. There are multiple futures-based bitcoin ETFs such as the ProShares Bitcoin Strategy ETF (BITO), ProShares Short Bitcoin ETF (BITI), VanEck Bitcoin Strategy ETF (XBTF), etc, as they have been allowed to trade since October 2021. BITO is the market leader with $2 billion in assets under management.

Outlook and Implications

ETF taxation starts with capital gains assessments, but they do not stop there.

If you sell your bitcoin ETF assets without holding them for a full year, the resulting short-term capital gains will be subject to ordinary income taxes. The tax rate could range from 10% to 37% based on your overall taxable income and filing status.

If you sell your shares after holding them for more than 12 months, the resulting long-term capital gains will be subject to capital gains taxes. The rate could be either 0%, 15%, or 20% depending on your overall taxable income and the filing status.

Additionally, if your income exceeds the following thresholds, you may also be liable for a 3.8% tax on top of the capital gains taxes explained above.

But that is not the only way that capital gains taxes could be assessed. Bitcoin ETFs spend small portions of bitcoin throughout the year to cover management fees. These transactions result in capital gains and losses due to the difference between the cost basis of the bitcoin spent and the market value at the time of spending. For instance, if a fund sells bitcoin at a $40,000 profit to pay for overhead, those gains will be taxed in proportion to each investor’s holdings in the fund.

Before the passage of the Tax Cuts & Jobs Act in 2018, investors could deduct their pro-rata share of fund expenses as a miscellaneous itemized deduction on Schedule A. Unfortunately, these expenses are not deductible until 12/31/2025 due to the limitations introduced by the act. These fees will become deductible again after 12/31/2025.

Futures contracts based bitcoin ETFs like BITO can have slightly different tax ramifications for holders compared to spot ETFs. The specifics depends on how these funds are structured, specifically whether they have underlying exposure to regulated or non-regulated §1256 futures contracts. If the fund has exposure to regulated futures contracts (these are typically traded on the dominant platform for bitcoin futures, the Chicago Mercantile Exchange), 60% of the gain is considered long-term, and 40% of the gain is considered short-term regardless of the holding period under §1256 of the IRS code.

If the fund has exposure to non-regulated contracts, gains are subject to normal capital gains rules similar to stocks. Note that the taxation of futures contracts can be very complex depending on the facts and circumstances of the contract, and certain tax elections made by the fund and you. These factors can have a significant impact on when and how much taxes one pays.

Additionally, if you deal with crypto futures ETFs, fund expenses are often paid in cash which will not result in the same capital gains or basis adjustments seen in spot ETFs.

Decision Points

ETF holders can expect two types of reports at the end of the year to comply with taxes, Form 1099-B and trust tax information statements.

Brokers will likely issue a Form 1099-B to report gains and losses resulting from disposing of ETF units. This form will report your cost basis of the ETF units, sales price, and the resulting gains and losses. (As per proposed broker regulations, starting the 2025 tax year, this information will likely be reported on the new Form 1099-DA dedicated to digital asset transactions).

Meanwhile, trust tax information statements (see Grayscale statements for example) will show the amount of BTC spent throughout the year to cover management fees. Spending BTC to cover fund expenses could result in a capital gain (or a loss). The document will show how to calculate your pro-rata share of capital gains or losses resulting from these transactions. You will have to calculate these manually by referring to the trust tax information statement as these will not be reported to you on a Form 1099-B. These statements are unique to ETFs set up as trusts. Most investors may not be familiar with these statements.

Finally, in the year you sell your ETF shares, the basis reported on the form 1099-B will need to be adjusted by incorporating information reported in trust tax information statements to arrive at the correct gain or loss. This could potentially make tax compliance cumbersome for the average taxpayer. That’s why it’s important to continue to monitor how the next spot BTC ETF approval goes.

Further Reading