How do U.S. residents pay taxes on personal investments in Bitcoin ETFs?

Compiled by: Shehan

Author: Chandrasekera

As the cryptocurrency industry rejoices over the long-awaited approval of Bitcoin spot exchange-traded funds (ETFs), investors must understand how the IRS will tax these products.

What is a Bitcoin ETF?

An ETF is a financial instrument that allows investors to invest in various assets and industries through a single share. A Bitcoin ETF enables investors to invest in Bitcoin without directly holding it. The launch of an ETF involves multiple participants. In a Bitcoin ETF, authorized participants (AP), typically market makers or large banks, provide cash to a 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 the AP. These ETF shares are subsequently 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 operating and management costs. As of December 31, 2022, the industry average expense ratio was 0.47%. Last but not least, regulatory participants, namely the Securities and Exchange Commission (SEC), must first approve the sponsor's application before the ETF can trade. Futures-based Bitcoin (or any other cryptocurrency) ETFs track Bitcoin prices 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), and VanEck Bitcoin Strategy ETF (XBTF). BITO, as the market leader, manages $2 billion in assets.

How are Bitcoin ETFs taxed?

The taxation of ETFs begins with capital gains assessment, but it does not stop there. If you sell your Bitcoin ETF assets in less than 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.

Additionally, if your income exceeds the following thresholds, you may also be subject to an additional 3.8% tax on top of the capital gains tax mentioned above.

However, this is not the only way to assess capital gains tax. Bitcoin ETFs will spend a small portion of Bitcoin throughout the year to pay management fees. These transactions can 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 at a profit of $40,000 to pay management fees, these 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 proportional share of fund expenses as itemized deductions on Schedule A. Unfortunately, due to the limitations introduced by that act, these expenses can no longer be deducted and will be deductible again after December 31, 2025. Compared to spot ETFs, futures-based Bitcoin ETFs (like 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 leading platform for Bitcoin futures, the Chicago Mercantile Exchange), then under 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 the fund is exposed to non-regulated contracts, the gains must comply with the 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 contracts, as well as certain tax elections made by the fund and you. These factors can significantly affect when taxpayers owe taxes and how much they owe. Additionally, if you are trading a cryptocurrency futures ETF, the fund expenses are typically paid in cash, which does not result in the same capital gains or basis adjustments as a spot ETF.

Key Tax Considerations for Bitcoin ETFs

ETF holders can file two types of tax compliance reports at the end of the year: Form 1099-B and trust tax information statements, to fulfill their tax obligations. Brokers may issue Form 1099-B to report gains and losses from the disposal of ETF units. This 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 statement will show the amount of Bitcoin used to pay management fees throughout the year. Using Bitcoin to pay fund expenses may result in capital gains (or losses). This document will explain how to calculate your proportionate share of capital gains or losses generated from these transactions. You must refer to the trust tax information statement to manually calculate this information, as it will not be reported on Form 1099-B. These statements are unique to ETFs established as trusts. Most investors may not be familiar with these statements. Finally, in the year you sell the ETF, you need to adjust the basis reported on Form 1099-B using the information included in the trust tax information statement to arrive at the correct gains or losses. This may make tax compliance cumbersome for the average taxpayer. That is why it is important to continue monitoring the progress of the next spot BTC ETF approval.