If you’ve sold or traded Bitcoin, Ethereum, or any other cryptocurrency this year, then you probably have a tax obligation. While crypto is largely anonymous, it is increasingly common for crypto trading sites and exchanges to issue users with IRS forms with a cost-basis estimate for easy for a relatively easy tax-filing process.
The IRS now considers crypto to be an investable property, just like equities and real estate, which means that it’s subject to capital gains and income taxes.
The good news is that there are a number of ways to minimize your crypto tax bill or defer it all together. In this article, we’ll explore some of the key strategies that investors can use to lower their tax liability.
But first….
How Do Crypto Taxes Work?
Undoubtedly, cryptocurrency is one of the hottest financial topics of discussion in today’s world.
Many investors have made a substantial amount of money by investing and trading in Bitcoin, Ethereum, and other digital assets. But just like any other investment, crypto has had its fair share of ups and downs, with some people losing a great deal of money, especially in recent days.
The IRS currently views all cryptocurrencies as property and not currency. That means when you buy, sell, or trade cryptocurrency, you have to pay taxes on any gains.
Generally, if you’ve held the asset for less than a year before selling it, your gain or loss will be considered short-term and taxed at your ordinary-income tax rate, ranging from 10% to 37% in 2021.
If you held it for more than a year, it will be considered long-term and taxed at the capital gains rate, which is lower than the ordinary income tax rate in most cases. IRS has 3 tax rates for long-term capital gains ranging from 0%, 15%, and 20% depending on your income.
Let’s put this into context.
- Capital gains: Capital gains kick in when you profit from the sale of an asset. For crypto, this would be when you convert your Bitcoin or other cryptocurrencies back into fiat currency, trade your cryptocurrency for other virtual currency, and use cryptocurrency to purchase goods or services.
- Short-term vs long-term capital gains tax rates: The difference between short-term and long-term gain is simply how long you have held the asset before selling.
- Ordinary income tax: This is the rate you pay on income from wages, tips, and interest from investments. Income events in crypto include things like staking rewards, mining rewards, referral bonuses, and airdrops.
Short-term capital gains are taxed as ordinary income according to your tax bracket, which ranges from 10% to 37% (based on 2021 code).
For long-term capital gains, the IRS has three tax rates that max out at 20%, but they only apply if your income is above certain thresholds. If you’re in the 10% or 12% tax bracket, you won’t owe any long-term capital gains tax.
How To Avoid Paying More than You Actually Owe
As you can see, the IRS has a complex system for taxing crypto gains and losses. Fortunately, there are a number of strategies that investors can use to lower their tax liability.
1. Invest for the long term
One of the simplest ways to reduce your crypto tax bill is to hold your assets for more than a year before selling. By doing this, you’ll be taxed at the long-term capital gains rate, which is lower than the ordinary income tax rate in most cases.
- Use tax-loss harvesting: Another way to reduce your crypto tax bill is to use a strategy called tax-loss harvesting. This involves selling your losing investments so that you can offset your capital gains and lower your tax liability.
For example, let’s say you bought 1 BTC for $28,000 in January of 2021 and sold it in December of 2021 for $31,000. You would have a short-term capital gain of $3,000, which would be taxed at your ordinary-income tax rate.
Now let’s say you also bought 1 ETH for $4000 in April of 2021 and sold it in December of 2021 for $2,000. You would have a short-term capital loss of $2000.
You can use this capital loss to offset your capital gains and lower your tax liability. In this example, you would only be taxed on $1000 of your capital gains, which would be at a lower rate than if you had not used tax-loss harvesting.
2. Take profits in a low-income year
This is also an excellent strategy for reducing your crypto tax bill. Crypto is taxed based on your income bracket in a given year. If your personal income is low in a particular year, you may be in a lower tax bracket and owe less in taxes.
For example, let’s say you’re a software engineer who makes $100,000 per year. In 2020, you had a great year and made $150,000. This puts you in the 24% tax bracket.
In 2021, you have a baby and decide to take a year off from work. This reduces your income to $50,000, which puts you in the 12% tax bracket.
If you were to sell your crypto in 2021, you would be taxed at the lower rate of 12%, rather than 24%. This can save you a significant amount of money in taxes.
3. Donate to charity
This is another great way to reduce your crypto tax bill. When you donate appreciated cryptocurrency to a qualified charity, you can deduct the value of your donation from your taxes.
This can be a great way to reduce your tax liability if you are in a high tax bracket and have a large amount of crypto to donate. You’ll enjoy 2 benefits: one, there is no capital gains tax and this can also trigger a charitable deduction.
4. Invest in a tax-advantaged account
If you’re looking for a more long-term solution, you can invest your crypto in a tax-advantaged account like an IRA or 401(k). This will allow you to grow your investment without having to pay any taxes on the gains.
You will have to pay taxes when you withdraw the money from these accounts, but you will likely be in a lower tax bracket than you are now. This can save you a significant amount of money in taxes.
5. Talk to a tax professional
If you’re serious about reducing your crypto tax bill, it’s a good idea to talk to a tax professional. They can help you understand the complex tax laws and find the best strategies for reducing your liability.
A good tax professional can also help you keep track of your crypto transactions and make sure you are reporting them correctly on your taxes. This can save you a lot of time and money in the long run.
Reducing your crypto tax bill doesn’t have to be difficult. By following these simple tips, you can save a significant amount of money on your taxes. Remember, always consult a tax professional before making any decisions about your taxes to avoid triggering an IRS audit.
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