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While tax season is over, it’s important to keep an eye on how you can minimize your liability in the year ahead. In this guide, we’ll cover the basics of cryptocurrency taxes and 5 simple strategies that can help you legally reduce your crypto tax bill!
How is cryptocurrency taxed?
To get a better understanding of how to save money on your taxes, we should first walk through the basics of how cryptocurrency is taxed in the United States.
Income tax: When you receive cryptocurrency as payment or earn it through activities like mining, staking, or referrals, you’ll recognize ordinary income.
Example: If Sarah earns $300 worth of staking rewards, she would report $300 as ordinary income on her tax return.
Capital gains tax: When you dispose of cryptocurrency — such as selling it, trading it for another cryptocurrency, or using it to make a purchase — you’ll incur a capital gain or loss. You can determine your capital gain/loss by looking at the difference between the sale price and your original cost for acquiring your crypto.
Example: Sean purchases $1,000 worth of Bitcoin (BTC). After a few months, he sells his BTC for $1,500. Sean incurs a capital gain of $500 ($1,500 - $1,000).
What’s the point of paying cryptocurrency taxes if it’s anonymous?
It’s a common misconception that crypto transactions are untraceable. Contrary to popular belief, the IRS has tools at its disposal to crack down on crypto tax evasion.
Major exchanges like Coinbase and Kraken are required to collect customer information and turn it over to the IRS upon request. In the past, the IRS has issued John Doe Summons to both exchanges to receive data on thousands of customer transactions.
Even ‘anonymous’ transactions that take place on-chain can be linked to known individuals. In the past, the IRS has worked with contractors like Chainalysis for this exact purpose.
Staying compliant with tax regulations is important if you wish to avoid trouble with the IRS in the future (which can come in the form of audits, fines, and even potential jail time!)
Instead of evading taxes, you can use tax optimization strategies to legally reduce your tax burden while staying compliant with the law!
How to save money on crypto taxes
Now that we’ve covered the basics of cryptocurrency taxes, let’s walk through 5 strategies to help you minimize your tax liability.
1. Hold your cryptocurrency for the long-term
The simplest way to reduce your cryptocurrency taxes is to hold for the long run.
Remember, the American tax code is written to encourage long-term investment and reward patient investors. If you hold your cryptocurrency for longer than 12 months, you’ll pay the long-term capital gains tax rate (0-20%). Disposing of your crypto after less than 12 months means you'll pay the ordinary income tax rate (10-37%).
Remember, simply holding your cryptocurrency doesn’t trigger any tax obligations. You can hold your crypto for as long as you want without incurring any tax liability!
2. Dispose of crypto in a low-income year
Selling your cryptocurrency during a low-income year can help you optimize your tax situation.
Remember, the tax rate you pay on your cryptocurrency is directly tied to your income for the year. The lower your income, the less tax you’ll owe when you sell your crypto.
If your income is lower in 2023 than you expect it to be in future years, taking profits today can potentially help you save thousands of dollars in taxes!
3. Harvest your losses
Disposing of your depreciated crypto comes with major tax benefits!
Capital losses can offset all of your capital gains and up to $3,000 of income for the year. Additional losses can be rolled forward into future tax years!
Remember, you need to dispose of your cryptocurrency to claim a capital loss. You can realize a loss by selling your depreciated cryptocurrency, trading it for another cryptocurrency, or using it to make a purchase. If you are still holding your cryptocurrency, you won’t be able to claim a capital loss.
4. Hold your cryptocurrency in an IRA
Planning to hold your cryptocurrency for the foreseeable future? You should consider holding your crypto in an individual retirement account (IRA).
At this time, most IRA providers don’t allow you to directly invest in cryptocurrency. However, you can invest in a self-directed IRA provider that allows you to invest in ‘alternative assets' such as cryptocurrencies.
Because there are penalties for withdrawing cryptocurrency from your retirement prematurely, IRAs are best suited for investors looking to hold their crypto for decades to come. If you’re planning to cash out your crypto in the short term, you should look towards the other strategies in this article to reduce your tax burden.
5. Donate cryptocurrency to charity
If you’re feeling charitable, consider donating your cryptocurrency to charity. Not only do you have the chance to make a positive impact, but cryptocurrency donations also come with tax advantages!
Cryptocurrency donations are a win-win scenario from a tax standpoint. Donating your crypto is one of the few scenarios where your ‘disposal’ is not subject to tax. In addition, you have the opportunity to claim your contribution as a tax deduction!
Remember, you’ll need to donate to a charity with 501(c)(3) status to be eligible for tax benefits.
By practicing tax optimization throughout the year, you can save thousands of dollars on your tax return! While there’s no legal way to evade cryptocurrency taxes completely, tax avoidance is an easy way to minimize your tax liability.