Cryptocurrencies are largely unregulated, but the IRS is cracking down on tax dodgers with an aggressive “John Doe” summonses campaign.Cryptocurrencies are taxed at long- and short-term capital gains rates, depending on how long you hold them and your income.You’re required to report cryptocurrency earnings and losses even if you don’t get a tax form from your exchange. Failing to properly report or pay taxes on your crypto transactions can result in legal and financial penalties. As we move into 2022, you still have time to reduce this year’s tax bill. If you can’t, now’s the time to start building more tax-efficient strategies for next year’s!
Historically, one of the hallmarks of cryptocurrency has been its anonymity. But in 2020, both the FBI and IRS increased their efforts to ensure crypto users aren’t breaking the law – or avoiding their tax bill. After all, where investors see profits, Uncle Sam sees tax potential.
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Unfortunately, crypto’s trademark anonymity and trailblazing technology make it more difficult to use. Though it’s designed as a currency, the IRS treats it like a security, injecting more murkiness into an already-intricate situation.
Still, its complexity doesn’t excuse you from paying taxes. And as the IRS decides how taxes work for investors (and how to make an example of tax dodgers), you don’t want to get caught in the crosshairs. Here’s what you need to know about cryptocurrency and your tax bill.
How Do Cryptocurrency Taxes Work?
In the United States, the IRS defines virtual currencies as property. For tax purposes, this relegates them to “capital assets” on par with stocks, bonds and even real estate. As such, crypto users must pay taxes on their gains, even if your broker doesn’t report transactions to the IRS. Conversely, you can claim crypto losses against other investments or ordinary income.
However, because they’re regulated like an investment and spent like money, cryptocurrency taxes aren’t as cut-and-dry as other securities. The IRS considers a taxable crypto transaction to include:
Exchanging cryptocurrencies for fiat money, or “cashing out” Paying for goods and services, such as a new Tesla or a cup of coffeeExchanging one currency for anotherReceiving mined or forked currencies
As you might imagine, this introduces quite a few wrinkles into the equation.
The Complexities of Crypto Taxes
For instance, say that you buy a cup of coffee with Bitcoin. If the price of Bitcoin has dropped since you bought it, your transaction proceeds as normal. You now own a cup of coffee; the IRS demands nothing from you; and you can’t write the loss off on your taxes.
But! If Bitcoin has increased in price since you bought it, the IRS demands that you pay capital gains taxes on the price difference from when you acquired and “sold” your Bitcoin. (And that’s on top of any applicable sales tax… convoluted, isn’t it?)
However, if you cash out your Bitcoin at a loss, you can write that off on your taxes. And if you trade one currency for another and make a profit, that’s a taxable event in the IRS’ favor.
Additionally, you can write off your expenses as business deductions on your taxes if you mine crypto. At the same time, you have to count your coins as regular, taxable income. That means you’ll owe tax on the fair market value of your crypto the day you receive it. You’ll also owe capital gains taxes on those same coins if you spend or sell them a profit later.
When Crypto Taxes Work in Your Favor
Fortunately, crypto tax rules can work for investors on occasion.
We’ve mentioned the losses briefly already. If you sell at a loss, you can claim a capital loss to offset profits in other cryptos and securities. You can also claim up to $3,000 in losses per year against your ordinary income to lower your tax burden.
Additionally, you can gift up to $15,000 in crypto per year without you or the recipient incurring a tax bill. (For gifts over the annual exclusion, rates range from 18-40%.)
There’s also one rule that investors can circumvent in 2021 – perhaps for the last time. At this time, the wash-sale rule, which prohibits claiming a loss if you sell and rebuy a “substantially identical” asset within 30 days, doesn’t apply to cryptocurrencies. However, legislation currently stalled in Congress would institute a wash-sale rule for cryptos as soon as 2022.
Current Capital Gains Rates
Any profits from your crypto transactions will be taxed as either short-term or long-term capital gains, depending on how long you hold your currency. Short-term capital gains, incurred on assets held under 12 months, are taxed at one of the 7 regular income brackets. Meanwhile, long-term capital gains are taxed at one of three special – typically lower – brackets.
IRSHow to Prepare for Capital Gains Taxes Now
Unfortunately, preparing for crypto-incurred capital gains taxes isn’t as easy as handling your stock transactions. Although the Form 1040 tax return asks about virtual currency transactions, crypto exchanges haven’t been required to file a 1099-B. (While a 2021 law now requires greater reporting standards, it doesn’t kick in until 2023.)
Until then, it’s up to you to do the legwork and start preparing for your crypto-incurred capital gains tax obligations.
1. Obtain a Record of All Crypto Transactions
The first essential step is to track down and record all your cryptocurrency transactions for this year. (And any previous tax years in which you didn’t file crypto capital gains taxes.) Be sure to note crucial information such as:
The dateHow much you paid (the cost basis)The number of coins purchasedYour profit or loss from selling, trading, or spending your currencyAny receipts received
Note that transactions between your own wallets, such as your online and offline wallets, don’t count for tax purposes.
If finding all this information sounds like a task and a half, you can hire a software company to scrub the blockchain for your transfers. And if you want to avoid this hassle in the future, you can always invest in cryptocurrency stocks instead of specific coins!
2. Fill Out and Double-Check the Proper Forms
Once you’ve recorded your crypto transactions, it’s time to fill out the proper tax forms. This includes Form 8949, which logs every crypto purchase, sale, or spend transaction. You’ll also need to fill out Schedule D, which summarizes your total capital gains and losses from all investments.
If you mine cryptocurrency, you may also be on the hook for a Schedule C or Schedule 1. Here, you’ll disclose whether you mine as a business or hobby, take certain deductions, and determine your self-employment tax obligations.
And while crypto exchanges aren’t yet on the hook for 1009-Bs, they do have to file 1099-Ks for high-transaction clients. Currently, the IRS is using these forms to find investors who may have shirked their taxes between 2016-2020.
4. Set Aside Your Tax Obligation
Every time you spend or trade cryptos at a profit, you incur a potential tax bill. As such, you may find it prudent to set aside your tax obligation as you go. And while it may be too late to save up in 2021, we’ve got a few smart tax moves to help you minimize your burden and navigate 2022.
5. How to Minimize Your Crypto Taxes Now – and in the Future
Just because Uncle Sam wants his share doesn’t mean you want to give it (not that we blame you). But instead of ducking the bill, try these legitimate strategies to limit high capital gains taxes on your crypto trades.
Hold Out for the Long-Term
Typically, you’ll see the most favorable tax treatment if you hold your cryptocurrency for a year or more. Depending on your taxable income, this can potentially shrink your tax rate from a high of 37% to 20%. (The difference between the highest long- and short-term capital gains tax rates.)
1. Sell Your Oldest Coins First
Say that you want to sell or trade some of your Bitcoin, but not all of it. Typically, you’ll incur the lowest tax bill by selling your oldest coins first. (Assuming that your oldest coins fall under the long-term capital gains tax rate.)
2. Take Capital Losses
You can use crypto losses to offset your gains and even your taxable income, just like with stocks and bonds.
Currently, you can claim up to $3,000 in excess losses against your income taxes. You can also offset your investment gains with investment losses directly, potentially “wiping out” your investment taxes.
Bear in mind that this strategy has limits. For instance, you must start by offsetting losses of the same type. (Long-term to long-term and short-term to short-term.) After that, you can use the “leftovers” to offset losses of the other type. Then, any remainder – up to $3,000 – can offset your income or carry forward into future years.
Of course, it’s usually best to talk your investment tax strategy through with a professional first!
3. Hold Your Crypto in Tax-Advantaged Accounts
One of the easiest ways to minimize your crypto taxes is simply choosing the correct accounts. By holding your cryptocurrencies in a tax-advantaged retirement account like a 401(k) or IRA, you can enjoy tax-free growth. You can also strategize around your current and future projected incomes to lower your lifetime tax burden, too!
However, this method comes with a few wrinkles – particularly when it comes to cryptos. First and foremost, some brokers haven’t caught up with the crypto trend yet. And among those that have, some may not allow volatile cryptocurrency holdings in retirement accounts.
Fortunately, this trend is expected to change in the coming years. Until then, the easiest way to buy crypto in a tax-advantaged account is with a specialty self-directed IRA. You may also be able to buy crypto ETFs comprised of multiple currencies.
4. Make a Charitable Donation
There is another way to minimize your cryptocurrency tax burden: with charitable giving. Rather than gifting cash, you can donate cryptocurrencies to qualified charities and nonprofits. Then, you can claim the appreciated market value of your donation as a deduction against your taxable income.
Fidelity, in particular, has set itself up as a leader in the crypto donation space. Under the Fidelity Charitable donor-advised fund program, you can:
Recommend how the contribution should be invested Grow your contribution tax-freeSee a worthwhile charity receive not only your donation but its potential growth, too!
Crypto Taxes Don’t Have to Be Difficult with Q.ai
The current tax landscape surrounding cryptocurrencies makes them surprisingly onerous to own and use. And with the IRS stepping up enforcement and surveillance, investors need to step more carefully than ever.
But Q.ai makes it easier to navigate the minefield of cryptocurrency tax obligations. With our all-new Crypto Kit, you can access exchange-traded trusts and a diversified fund that invests in cryptos like Bitcoin, Ethereum and Litecoin.
Then, we package your profits and losses in a tidy set of documents at the end of the year. Get ready to reap the potential benefits of investing and crypto all in one!