While many investors who got on board with cryptocurrency early on may have appreciated the fact that cryptocurrency transactions were largely “under the radar,” that is no longer the case. In fact, the Internal Revenue Service has taken a firm position about the taxation of cryptocurrency, defining the asset class as “property” under the U.S. tax code. Thus, any time you sell bitcoin or any other cryptocurrency for a profit, it is a taxable event. In addition, the IRS has realized that there are many investors who are not fulfilling their cryptocurrency tax obligations and is cranking up its enforcement efforts. For example, five years ago, who would have thought one of the first questions on IRS Form 1040 would be, “At any time during [the taxable year], did you receive, sell, send, exchange or otherwise acquire any financial interest in any virtual currency?”
However, for many investors, cryptocurrency gains can be substantial. Cryptocurrency has proven to be very volatile, leading many investors to rack up enormous paper gains. Of course, when these investors go to cash out on their crypto gains, they are going to incur a massive tax hit. One way to avoid this is to defer your cryptocurrency gains. Below are a few strategies for deferring cryptocurrency gains.
Don’t Forget About Your Losses
As an investor, you may be tempted to forget about your losses and focus on your victories. However, when it comes to the taxation of cryptocurrency, losses should not be overlooked. This is because the IRS allows you to offset your gains by claiming your losses from the same year. In the event you took an overall loss for the year, you can use your cryptocurrency losses to offset up to $3,000 of your ordinary income for the same year.
Don’t Sell for a “Short-Term” Gain
Bitcoin, Ethereum and other cryptocurrencies are considered property by the IRS. Thus, the tax rate you must pay on your cryptocurrency gains depends, in part, on how long you held the investment. Cryptocurrency transactions are taxed as either short-term or long-term gains. A short-term gain is defined as a buy and a sell occurring within 365 days. Long-term gains are logged when you sell cryptocurrency after holding it for more than a year.
The short-term gain tax rate for cryptocurrency is the same as for other short-term gains. For example, in 2021, the short-term tax rate ranges from 10% to 37%, depending on your income. The rate for long-term crypto gains in 2021 is significantly lower, ranging from 0% to 20%, again, depending on your income.
If you are considering selling cryptocurrency, you could reduce your tax hit by waiting until you’ve held the assets for at least a year. That way, your effective tax rate decreases significantly.
For longer-term holders that do not need to sell their cryptocurrency, it may make sense to hold off on selling. As mentioned above, the tax rate for cryptocurrency gains ranges between 10% to 37% for short-term gains and 0% to 20% for long-term gains. If you can wait to sell your bitcoin during a year in which you make less money, your overall cryptocurrency tax rate will be lower.
Buy Crypto in a Traditional IRA
One of the easiest ways to (legally) avoid paying taxes on your cryptocurrency is to purchase cryptocurrency in your traditional IRA. A traditional IRA is a retirement account in which you deposit pre-tax income. Thus, when you buy crypto in a traditional IRA, you are buying it with money that hasn’t been taxed. Selling crypto in an IRA isn’t a taxable event because you are only taxed at the point you withdraw money from the IRA. While you still must pay tax at the time of withdrawal, for most people, this allows them to strategically time the withdrawal to minimize their tax liability.
Buy Crypto in a Roth IRA
Roth IRAs are similar to a Traditional IRA, with a few major differences. First, you can only deposit taxed money into a Roth IRA. However, when you make a withdrawal, you will not pay taxes on any gains. This can make a huge difference for successful crypto investors.
Gift Your Crypto to Friends, Family Members or Charity
Through strategic gifting, you can drastically reduce your tax liability as it pertains to cryptocurrency gains. For example, the IRS allows you to make annual gifts of $15,000 (2021) or $16,000 (2022 and onward) to as many people as you’d like. Further, these annual gifts do not count towards the annual gift and estate tax exclusion. Additionally, if you decide to gift your bitcoin or other cryptocurrencies to a qualifying charity, you will not need to pay any tax on the gains.
Move to a State with Low or No Income Tax
It’s obviously not the most practical solution to your cryptocurrency tax woes, but moving to another state with a low or non-existent income tax can reduce your tax hit when selling cryptocurrency for a gain. There are nine states that do not impose capital gains taxes on cryptocurrency sales: Wyoming, Washington, Texas, Tennessee, South Dakota, New Hampshire, Nevada, Florida, and Alaska. Alternatively, if you have a move on the horizon, be sure to consider the tax implications of selling crypto both before and after the move.
Speak with a Cryptocurrency Tax Lawyer for other Creative—and Legal—Ideas
Aside from the list of ways to defer your cryptocurrency gains, there are a host of other strategies that may be available to you. Consulting with a crypto tax lawyer can give you some unique ideas that could save you tens of thousands of dollars, depending on your tax liability. Additionally, when it comes to the taxation of cryptocurrency, it is essential to ensure you comply with all laws because the IRS is keeping a close eye on cryptocurrency investors these days.
The most important thing cryptocurrency investors need to keep in mind is the importance of planning ahead. Crypto tax lawyer and founder of Oberheiden, P.C., Dr. Nick Oberheiden, explains, “For those who have significant unrealized cryptocurrency gains, it is imperative that they take the time to develop a well-thought-out plan when it comes to selling. Many investors are being surprised by astronomical tax bills that eat into a high portion of their gains. While this is undoubtedly frustrating, the real frustration comes when they learn that they could have reduced their tax liability by taking a few simple steps.”
Given the IRS’s recent efforts to root out tax evasion among cryptocurrency investors, it is imperative that investors take a comprehensive and strategic approach to turning paper gains into realized gains. Working with an experienced cryptocurrency tax lawyer takes the guesswork (and risk) out of the process.
Contact us today.