Five years ago, most people had barely heard of cryptocurrency. Even a year or two ago, most people didn’t own any. But recently, cryptocurrency has increasingly burst into the public awareness, and more and more people are investing in it — perhaps not fully understanding what it is, or the tax consequences of owning and transferring it. Cryptocurrencies such as Bitcoin, Ethereum, Litecoin, and Dogecoin are no passing fad, so it is worth understanding cryptocurrency tax — and how to minimize what you pay.
It’s not hard to understand tangible property: real estate, vehicles, land, art. You can see it and touch it. Though you cannot see and hold cryptocurrency, rest assured that in the eyes of the IRS, it is just as much property as those other assets, and it is taxed in just the same way. Units of cryptocurrency are called “coins,” and like other investments, they are subject to capital gains tax.
Let’s pause for a brief primer on capital gains. A capital asset is an asset that you can own for investment purposes, like cryptocurrency. Capital gains are profits realized from the sale of a capital asset. Capital gains are taxed in one of two ways:
Short-Term Capital Gains: A capital gain is “short-term” when you have held the asset for less than 365 days before selling it. Short-term gains are taxed as ordinary income, with tax rates ranging from 10% to 37% for tax year 2021.
Long-Term Capital Gains: Profits on assets held for longer than a 365-day period are considered long-term capital gains. Depending on the taxpayer’s income, long-term capital gains are taxed at 0%, 15%, or 20% — much more favorable than the short-term rate.
Of course, there is the possibility of “capital losses” as well, when the asset is sold less for its cost basis. Capital losses can be used to offset capital gains for tax purposes.
If you are interested in cryptocurrency as an investment, you have numerous options for minimizing the cryptocurrency tax burden. Some, like picking up and moving to a state with no state income tax, might not be practical for you. But others require surprisingly little effort — just a little forethought and planning.
The first strategy is the most obvious and literally requires you to do...nothing. If you can afford to hold onto your cryptocurrency for more than a year, your capital gains will be taxed at the more favorable rate for long-term capital gains.
If you tend to have consistent income from year to year, this may not be the strategy for you. But many of us have income that fluctuates from year to year. Whether you are facing short- or long-term capital gains tax on cryptocurrency, your rate will be lower if your income is lower. If you have the option of selling cryptocurrency in a year in which you expect to have less income, do so.
On a related note, there may be ways in which you can lower your taxable income in a given year through tax deductions and credits. Do you have a health savings account (HSA), 401(k), or traditional IRA to which you can max out contributions? Talk to your tax preparer about ways to lower your taxable income so that you won’t take as big a tax hit on capital gains from cryptocurrency sales.
Nobody likes taking a loss on an investment, but if you do, the silver lining is that you can use it to offset other gains. As a general rule, you need to offset short-term gains with short-term losses and long-term gains with long-term losses. However, if you have remaining short- or long-term losses after offsetting gains of the same type, you may then be able to use them to offset capital gains of the other type, such as offsetting a short-term gain with a long-term loss.
Giving your cryptocurrency to a family member is another way to reduce your taxes, depending on your situation. You (and your spouse, if you are married) can gift $15,000 to each recipient each year without tax consequences. If you make a gift of cryptocurrency to a family member during your life, they will take your cost basis in the property.
In other words, if you bought a coin at a cost of $1000, and it appreciates to $2000, you would recognize a gain of $1000 if you sold it (sales price minus cost basis). So would a person to whom you gifted the coin before it was sold. However, if you gave the coin to your adult child who has less income than you, they would pay less in tax on that gain, or perhaps nothing at all.
This strategy contemplates a lifetime gift, but you could also leave your cryptocurrency to your children or grandchildren on your death. If you do, and the current tax laws on step-up in basis don’t change between now and then, your beneficiaries will get an added benefit. Their basis in the crypto will be the value of the currency at the time of your death, not when you purchased it. Assuming the cryptocurrency has appreciated in value, their taxable capital gain will be less with the step-up in basis.
You don’t have to give your crypto to your kids to get a tax benefit. If you are charitable-minded, donating your appreciated cryptocurrency to a favored charity can net you a triple benefit: you make a meaningful financial contribution to a cause you support; you don’t pay capital gains tax on the appreciation; and you get a charitable deduction on your income tax.
If you choose to fund a tax-free or tax-deferred self-directed IRA with your cryptocurrency, you can realize a significant tax benefit. If, like many people, you expect to have lower taxable income in retirement, you can invest in a traditional IRA and pay deferred taxes on the cryptocurrency when your tax rate is lower. If you expect to have a higher income in retirement than you do now, you may want to pay taxes up-front on the cryptocurrency by having a self-directed Roth IRA.
Cryptocurrency can be a great investment, but don’t let poor tax planning put a dent in your gains. If you are interested in reducing your tax on cryptocurrency, schedule an appointment today with the accounting and tax preparation professionals at Gudorf Tax Group.