How to Reduce Taxes on Cryptocurrency Gains

Cryptocurrency activity is everywhere, and it’s no longer just for the investment elite or bitcoin miners. Whether you’re investing in cryptocurrency or spending it, trading in digital currency can often feel like you’re not dealing with “real” money.

But, this isn’t the case. Trading in cryptocurrency can have real federal income tax implications. This article will look at the six most effective ways to reduce taxes on your cryptocurrency gains. First, it’s worth looking at exactly how the IRS taxes cryptocurrencies so you can better understand your potential liabilities.

Cryptocurrencies and Tax

While cryptocurrencies can be used to purchase goods and services, the IRS treats cryptocurrency as transactions in a property. This is true whether you use digital currency to buy something or use it as an investment vehicle. As a result, your cryptocurrency activity will be taxed alongside other capital asset transactions like sales of real estate, equipment, vehicles, stocks, and bonds.

This means that all the following transactions are taxable:

• Paying for goods and services with cryptocurrency
• Selling cryptocurrency for “real” money
• Mining cryptocurrency
• Buying one cryptocurrency with another
• Receiving cryptocurrency as a reward

In these transactions, your gain or loss will be calculated based on the fair market value the day you sold or used the cryptocurrency compared to the basis you have in the asset. For most people, their basis in a crypto asset is what they paid for it.

The IRS doesn’t mess around, either. The Treasury Department is aware of the potential to use digital currencies in tax avoidance schemes. Starting in 2019, it added a question to tax return forms that inquire about cryptocurrency transactions.

It’s also worth mentioning that your cryptocurrency transactions are dependent on your country of residence. This means that even if you spend your cryptocurrency in a foreign market, you must apply U.S tax rules to those transactions if you live in the United States.

Six Methods to Reduce Taxes on Cryptocurrency Gains

Now that we understand how the IRS taxes cryptocurrencies, we can look at the best ways to reduce your taxes on crypto gains.

1. Use a Self-Directed IRA –
   A self-directed IRA is a type of retirement account designed for alternative assets typically prohibited in traditional or ROTH IRAs, such as precious metals, commodities, real estate, and – yes – cryptocurrency. Like traditional IRAs, self-directed IRAs are tax-deferred. This means you will only be taxed on your account growth when you withdraw those assets in retirement. If you are in a lower tax bracket in retirement, your gains will be subject to a lower tax rate than if you traded those assets today.
   A unique way to fund a self-directed IRA is to transfer money from another traditional or Roth IRA in a rollover. Once those rollover proceeds are in your self-directed IRA, you can use them to purchase cryptocurrency assets.
2. Utilize the 0% Long-Term Capital Gain Tax Rate –
   Capital gain is the difference between what you paid for an asset and the price for which you sell it. The tax you pay on this gain depends – in part – on how long you held onto the asset.
   If you held onto a crypto asset (or any other capital asset) for at least 12 months before selling it, the gain or loss you recognize would be long-term. Long-term capital gains are taxed more favorably than short-term capital gains. Long-term capital gains are taxed at 0%, 15%, or 20%, depending on your filing status and annual income. For example, in 2021, a married couple reporting less than $80,800 in taxable income would be eligible for the 0% long-term capital gains tax rate.
   But even if you are in the highest long-term capital gains tax bracket of 20%, your capital gains will be taxed more favorably than ordinary (or earned) income that you report, making cryptocurrencies a taxpayer-friendly investment.
3. Take Advantage of Tax Loss Harvesting –
   Tax-loss harvesting is the process of selling assets for a loss to reduce your capital gains.
   It’s typically ill-advised to choose to sell assets at a loss. Under most circumstances, you would only use this technique if you had assets that (1) had already lost value and (2) were unlikely to regain their value in the near future. In these instances, you can keep these assets in your portfolio until you have capital gains to report, at which time you can “harvest” those losses. Offsetting capital gains with these accumulated losses is a simple way to manage your taxable income.
   But this technique becomes even more valuable with cryptocurrencies because crypto assets aren’t subject to the IRS’s wash sale rules. Typically, if you sell a security and then repurchase a similar asset within 30 days, the IRS will not let you deduct losses from your original sale. They will consider the sale and subsequent purchase of a wash. But crypto assets aren’t currently subject to these same rules. With a bit of careful planning, you can sell some of your cryptocurrency assets to harvest losses while the market is low and then reinvest the savings to regain your position.
4. Donate to Charity –
   If you donate digital currencies directly to a charity, you can avoid paying tax on the realized gain from your investment. Your charitable deduction would be equivalent to the fair market value of your asset when you donated it. If you instead chose to sell the cryptocurrency and donate the proceeds to charity, you would receive the same charitable deduction, but you would have to pay capital gains tax on the profit.
   For example, let’s say you bought one bitcoin for $8,500 two years ago. Today, your bitcoin is worth $37,500. When you donate your bitcoin to charity, you would report a $37,500 donation on your tax return, but you would not have to pay tax on the $29,000 gain.
5. Invest Profits into a Qualified Opportunity Fund –
   In late 2017, Congress introduced a tax incentive that rewards taxpayers for investing in qualified opportunity funds (QOFs). QOFs are investment vehicles explicitly built to fund and support projects in economically depressed communities.
   When taxpayers generate a capital gain and transfer that gain into a QOF, they can reap the following benefits.
   1. If they hold onto their QOF investment through the end of 2026, they can defer their original gain until January 1, 2027.
   2. If they invest in a QOF before the end of 2021 and hold onto their investment for at least five years, they can exclude 10% of their original gain via a basis adjustment.
   3. If they make a QOF investment before 2027 and hold onto their investment for at least ten years, they can permanently exclude all growth that occurred within the QOF.
   Gains from any capital asset sale can be invested into a QOF, including crypto gains. But to reap all the benefits of QOF investment, you must transfer your crypto gains into a QOF within 180 days of the sale.
6. Use the Highest-In-First-Out Method –
   When you own multiple units of a digital currency acquired at different times, it can be hard to identify which specific assets you’ve sold. Determining which assets you’ve sold is essential when the basis amounts differ. By default, cryptocurrencies will be assumed to have sold on a first-in, first-out basis. However, the IRS recently clarified that you could self-select the specific assets that you sold as long as you can identify the following:
   1. The date and time you acquired each unit,
   2. The fair market value when you acquired it,
   3. The date and time you disposed of each unit, and
   4. The fair market value at the time of disposal.
   By hand-selecting the assets you’ve sold, you can optimize the gain/loss you recognize from each sale. A common method for minimizing gains from the sale of digital assets is to use the highest-in, first-out method. This method implies that you sell your coins with the highest cost basis first. This will produce the lowest capital gains and the most significant capital losses.
   To be successful at the highest-in, first-out method, you’ll need to track your cryptocurrency activity closely. A crypto-specific tax software might be worth the investment since some currency exchanges don’t track the basis.

Proactive Tax Planning is a Must

As with any investment property, there are various ways to reduce your tax expenses with cryptocurrency. But doing it properly requires knowledge and expertise, so be sure to consult a tax advisor before proceeding with any of the techniques discussed above.

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©2021 Klatzkin & Company LLP. The above represents our best understanding and interpretation of the material covered as of this post’s date and does not constitute accounting, tax, or financial advice. Please consult your advisor concerning your specific situation.