IRS Tax Approach to Bitcoin ETFs Decoded

The IRS’s approach to taxing Bitcoin ETFs is crucial for investors as they navigate the recent approval of bitcoin spot exchange-traded funds (ETFs). These financial instruments allow investors to access bitcoin without owning the cryptocurrency directly, but understanding their tax implications is paramount.

ETFs, including those for bitcoin, are complex financial products involving various parties and processes. Authorized participants (APs), typically market makers or large banks, contribute cash to a grantor trust set up by sponsors like Ark Invest or Blackrock. The trust then buys bitcoin using this cash and issues shares representing the bitcoin to the AP. These shares are sold to retail investors through public exchanges like NYSE or Nasdaq, with ETF sponsors charging an annual fee to cover costs.

For futures-based bitcoin ETFs like ProShares Bitcoin Strategy ETF (BITO), which began trading in October 2021 and has $2 billion in assets, the taxation differs. These ETFs track bitcoin prices through futures contracts, with gains subject to capital gains taxes. If sold within a year, short-term capital gains are taxed as ordinary income, ranging from 10% to 37%. Selling after a year incurs long-term capital gains, taxed at 0%, 15%, or 20%, depending on income and filing status, plus a potential 3.8% tax for higher earners.

However, capital gains taxes aren’t just from selling ETF shares. The funds spend small amounts of bitcoin throughout the year to cover fees, resulting in gains or losses for investors. Before 2018’s Tax Cuts & Jobs Act, investors could deduct their share of fund expenses, but this is now postponed until 12/31/2025. For futures-based ETFs, gains from regulated futures contracts are split 60% long-term and 40% short-term, regardless of holding period, under IRS code §1256.

Tax compliance for ETF holders involves two key documents: Form 1099-B and trust tax information statements. Brokers issue 1099-B to report gains and losses from disposing of ETF units, detailing cost basis, sales price, and resulting gains or losses. Trust tax information statements, like those from Grayscale, show BTC spent to cover management fees, potentially resulting in capital gains or losses. These statements require manual calculation and adjustment of the basis reported on Form 1099-B, adding complexity to tax compliance.

Understanding how the IRS taxes bitcoin ETFs is crucial for investors, especially as more ETFs are expected to be approved. It’s essential to stay informed and seek professional advice to navigate the tax implications of these investments effectively.