It seems like everyone’s getting into digital assets these days.
From cryptocurrencies like Bitcoin and Ethereum, to NFTs (non-fungible tokens) and blockchain software, we’re in the midst of a digital gold rush. And part of the attraction was how decentralized it promised to be—free of banking oversight, government control, and government taxing authority.
At least that’s how it started out. But the IRS knows all about digital assets these days, and that’s why we’ve compiled this cryptocurrency tips and taxes guide.
The short of it is this: the IRS classifies crypto as a form of property. And that means when you sell it and make a gain, the government wants a piece of the action.
So let’s learn some more about how the tax on cryptocurrency works, and check out some tips on how to lower your share of it.
Cryptocurrency Tips and Taxes
Before we delve into the wild world of cryptocurrency taxes, let’s first understand some cryptocurrency basics.
Cryptocurrencies are a form of digital asset, and they’re relatively new to the world stage—the first, Bitcoin, only appeared in 2009. As with real-world, fiat money, cryptocurrencies can be used to acquire goods or services. Despite this practical side of things, many like to invest in crypto in much the same way as one would invest in stocks.
The appeal for these digital assets is twofold. First, they are decentralized (for the time being), which means these digital currencies operate independently of central banks and other financial institutions.
Second, they are very secure, since they run on sophisticated blockchain technology. The blockchain operates as a public, digital ledger, which allows everyone to observe transactions and verify their legitimacy.
In short, cryptocurrency transactions are fully transparent, and the blockchain works to obviate the kind of chicanery and legerdemain that financial institutions traffic in.
Bitcoin and Ethereum are among the most famous cryptocurrencies. But there are in fact many thousands of different cryptocurrencies, some of them legitimate and others representing a lark. Whether these other contenders have any staying power remains to be seen.
Cryptocurrency Tax: How It Works
Now let’s take a look at cryptocurrency tips and taxes, beginning with how a tax on cryptocurrency actually works.
Although crypto is called a digital asset, it’s not considered a real currency by the IRS. In Notice 2014-21, the IRS classified virtual currencies as property, and it deemed that capital gains and losses associated with this “property” must be reported as per the usual methods.
Capital gains and losses can be divided into long-term and short-term categories, which relates to how long you kept the cryptocurrency before divesting these assets. For instance, if you held the crypto for a year or less before spending or exchanging it, this would be considered a short-term gain or loss.
If, on the other hand, you held onto the crypto for more than a year, the profits of any sale of these assets would be considered a long-term capital gain. This falls under the rules of long-term capital gains tax rates.
Cryptocurrency mining is an important part of the digital currency economy.
“Mining” in this case involves using raw computer processing power to solve complex mathematical problems. Solving these equations validates a “block” of crypto transactions and adds it to the blockchain.
The reward for this mining work comes in the form of a given cryptocurrency, which is why mining is one of the methods for acquiring these digital assets. In the case of cryptocurrency mining, the IRS regards this as taxable income.
You report these assets on Form 1099 as you would any income earned through self-employment. The digital assets should be assessed at the market value on the day you received them.
Another aspect of crypto tax has to do with cryptocurrency payments.
Quite a few businesses are now accepting Bitcoin and other cryptocurrencies in lieu of ordinary, fiat money. In these cases, the payment is considered to be taxable income, no different than paying with regular cash. To report these taxes, the fair market value of the crypto on the day it was paid is sufficient.
Selling or Spending
Things get a little more complicated when you sell and spend your cryptocurrency assets. In short, it represents a capital transaction that’s no different than selling stock market shares.
The basic formula is fairly simple. The base value of your cryptocurrency assets represents the market value (in USD) for that crypto when you received it.
However, unlike the US dollar, cryptocurrency prices are volatile, and they can fluctuate wildly over time. So you might find that after a few months, the value of the crypto you received has appreciated.
So if you initially received $1,000 worth of crypto, you might find its value has doubled. Now, months later, you purchase the equivalent of $2,000 worth of goods and services with the same amount of crypto. For tax reporting purposes, you’d report $1,000 as your income, with a short-term capital gain of $1,000.
That doesn’t seem too difficult. But things get tricky in real life, when you’re using crypto to make hundreds of small purchases over time—just as you would with ordinary money. Obviously, few people would meticulously track these everyday purchases, which is why tax reporting at the end of the year would become a Sisyphean task.
It’s also possible to exchange various cryptocurrencies for one another.
In these instances, you would have to report the amount of capital gain (or loss) that you incurred when you made the exchange. So if you exchanged $500 worth of Solana for $500 worth of Dogecoin, and you initially paid $200 for the Solana, you would note a $300 capital gain on your tax forms.
As far as enforcement is concerned, the IRS has been much more active of late.
With more people than ever joining the cryptocurrency craze, Uncle Sam has become alarmed and wants his cut. After all, the IRS figures very few people are reporting their cryptocurrency transactions in any conscientious way.
To rectify this situation, the IRS has now made changes to Form 1040. The document now includes questions about whether the tax filer has received, sold, or otherwise exchanged virtual currencies.
If the answer is yes, you’d better be prepared to document these transactions.
Cryptocurrency Tax Tips
To boil everything down for you, we can safely say that the crypto tax is really a capital gains tax.
And as with any tax, it’s important to have a strategy in place so you can reduce the amount you pay in IRS taxes as much as possible. Fortunately, you’ve come to the right place—to help you out, we’ve compiled this list of seven tips for cryptocurrency tax help.
1. Offset Gains With Losses
It helps to balance or offset your capital gains with capital losses.
In essence, the way this works is by offsetting whatever losses you incurred when you sold your digital assets. You simply subtract these losses from your crypto gains, accrued through asset appreciation during the course of the year.
It’s important to understand the basic caveat that comes with this strategy. There are built-in limits to how much it can be used. For one thing, it’s an apples-to-apples strategy. You can only offset investment losses that fall into the same category.
In other words, short-term capital losses can only be subtracted from short-term gains; ditto for long-term losses and gains. With that proviso understood, you can go about offsetting your capital gains taxes of either class with any net losses your crypto holdings may have incurred.
2. Know When to Sell
This next tax tip is about knowing how to play the game. It all comes down to timing, and sometimes your best option is to sell your cryptocurrency assets in a low-income year.
Using this strategy is a good way to reduce taxes on long-term and short-term capital gains. So if you’ve accrued long-term capital gains from your crypto assets, selling when your yearly income is lower translates into a lower tax rate.
The reason is that your rate is based on your income level for the year. If you sell when your taxable income is at its lowest, you won’t have to pay such hefty long-term capital gains tax.
Short-term gains, on the other hand, are taxed as ordinary income. The theory is the same in this instance: sell your crypto in a low-income year to avoid being boosted into a higher tax bracket.
3. Know When to Hold ‘Em
It follows from the above crypto tax tip that knowing when to hold on to your digital assets is just as important as knowing when to sell them.
To lower your taxes, you need to have the patience to convert your short-term gains into long-term ones. Long-term capital gains have a lower tax rate than short-term gains, so it’s wisest to ignore the urge to sell before a year is up.
Of course, this is easier said than done. The crypto markets are notoriously volatile, and it can be tempting to want to sell off assets with every wild dip or exhilarating high. Do yourself a favor—resist this temptation, and don’t sell until at least a year has passed.
4. Invest in Crypto
While you’re at it, find ways to invest your crypto wisely to lower your taxes. One potential strategy is to invest it in tax-free or tax-deferred retirement plans. If you expect to have a lower income after retirement, you can defer your taxes until that time.
Or, if you expect taxes will be higher upon retirement, you can pay them upfront. Either way, you’re trying to avoid being crushed when it’s time to cash out on that crypto.
5. Reduce Taxable Income
Another good strategy is to reduce your overall taxable income. There are many ways to accomplish this goal, but it means doing your homework and scanning the tax codes and regulations.
It might be worthwhile to hire a tax professional to help you find various loopholes and tax deductions. Contributing to a 401(k) or IRA plan is one way, as is squirreling money away in health savings accounts.
Another consideration is to donate some of your cryptocurrency to charity. A donation like this helps you avoid the capital gains tax.
It also means you can claim a sizable tax deduction when tax season comes around. This course is especially attractive if you’re passionate about supporting a particular cause or organization.
6. Make a Bequest
There are also some creative ways to minimize cryptocurrency taxes.
One of these is to include digital assets in your will. Doing so is an excellent way to grow the wealth of your crypto holdings while at the same time benefiting your heirs or beneficiary institutions.
After your death, your crypto assets will receive a “stepped-up basis,” affixing their base value to the fair market price at the time of your death. That can be a big help, given the notorious volatility of cryptocurrencies.
So even if the value of your crypto assets rises sharply after your death, your beneficiaries will only be taxed on their stepped-up basis.
7. Locate to a Low-Tax State
Let’s not forget the dreaded state and local taxes. After all, the feds aren’t the only tax-consuming entity staking a claim to your assets.
The solution here is pretty simple if you’re willing to take action: relocate to a low-tax state. There are several states that don’t assess income tax, or have very low income tax.
Of course, changing states is a major undertaking, with concomitant changes in lifestyle and perhaps the quality of life. But every bit helps, and it could be worth it to switch states if you want to avoid taxes on your digital assets.
Lower Your Crypto Taxes
Everyone wants to participate in the crypto craze.
But if you’re ignorant of the tax policy surrounding these remarkable new digital assets, you can get hurt when tax season comes around. IRS guidelines are fluid and uncertain, and they will most likely continue to change as cryptocurrencies grow in popularity.
This is why it helps to stay informed about tips and taxes. Fortunately, you’ve come to the right place to learn more about how to minimize your taxes.
Explore the rest of our tax section to discover more tax tips and helpful strategies.