Bitcoin has increased by more than 1,700% in 2017 alone, so it's fair to assume that there are many people who are sitting on some serious profits. Whether you've sold BTC at a profit or are continuing to hold on for the ride, or even if you've paid for things in BTC, you need to know the tax implications of cryptocurrencies, as well as two ways you could potentially reduce your tax bill.

How bitcoin profits are taxed

The IRS has classified bitcoin, and other cryptocurrencies, as capital assets. This means that if you buy BTC at one price and sell it at a profit, you are taxed on the gain, just as if you had bought a stock that appreciated in value and then sold it.

IRS Form 1040 with money scattered on top.

Image Source: Getty Images.

It's also worth pointing out that capital gains taxes only apply when assets are sold. In other words, even if you spent $1,000 on BTC in the early days and your investment is now worth millions, the IRS can't collect a penny in taxes until you cash in.

Are you keeping track? You should be

I've written before that the way bitcoin is taxed is one of the biggest obstacles that could prevent it from becoming a mainstream currency -- at least in the United States. And when I said that, I wasn't so much referring to the tax on sales of bitcoin as I was the tax implications of using it to pay for goods or services.

Consider this scenario. You buy $10 worth of bitcoin and the value of your bitcoin rises to $30 over the next few months. You then go to the store and pay for a $30 purchase with your bitcoin. Well, since you originally paid just $10 for your bitcoin, this represents a $20 gain, even though you spent the bitcoin rather then selling it, and would be considered a taxable capital gain.

While a one-time situation like this wouldn't be terrible, imagine if you used bitcoin as your only payment method. You're expected to keep track of every transaction and whether it resulted in a capital gain or not.

Long-term vs. short-term capital gains

One way to lower your tax bill is to hang on to your bitcoins for at least a year. The IRS treats long-term capital gains more favorably than short-term gains.

Specifically, the IRS defines a short-term capital gain as a profit made on an asset that you held for one year or less. If this is the case, your gains are taxed at your ordinary marginal tax rate.

On the other hand, if you held the capital asset in question for at least a year and a day, lower tax rates apply. Depending on your marginal tax bracket, your long-term capital gains tax rate is 0%, 15%, or 20%. Here's a breakdown:

Marginal Tax Bracket / Short-Term Capital Gains Tax Rate

Long-Term Capital Gains Tax Rate















Data Source: IRS.

Give some of your bitcoins to charity

Another possible way to lower your taxes, even if you aren't planning to sell any of your bitcoins, is to donate some of them to charity. And if you plan to contribute cash to charity, consider donating bitcoin directly instead.

If you do this, you get to deduct the fair market value of the bitcoin you donate, as determined on a qualified appraisal, at the time the donation was made. The IRS allows for deductions equal to the market value of appreciated capital assets of as much as 30% of your adjusted gross income. So, if your AGI is $100,000 for 2017, you have the ability to donate as much as $30,000 worth of bitcoin to a charity and deduct every penny from your taxable income. The list of charities that accept bitcoin is growing rapidly, so you should have plenty to choose from.

The bottom line

If you're holding bitcoin that's worth more than you paid for it, or if you've already sold or spent appreciated bitcoins, it's important to know the tax rules that pertain to bitcoin as well as strategies to keep your taxes as low as possible. After all, the goal should be to pay all of the tax you are legally required to, but not a penny more.