9 Ways to Cut Crypto Taxes Down to the Bone
Once you know how cryptocurrency is taxed, you can focus on strategies to minimize how much crypto tax you’ll have to pay the IRS.
Cryptocurrency is one of the hottest topics in the financial news right now. Although it's a volatile market, statistics show that crypto investors have turned significant profits in the technology's early innings. Over the past few years, we’ve certainly seen a lot of people make a lot of money by buying and selling virtual currencies.
Perhaps you've already bought some cryptocurrency yourself. If so, you'll eventually need to find the right time to cash out on the cryptocurrency bonanza. But before you reach that point, you should think about how you’re going to deal with crypto taxes. That's right – if you sell for a gain, Uncle Sam will most assuredly want his cut. So, while the virtual currencies might not actually exist, the tax payments you'll need to make most certainly do.
Naturally, you want to minimize your crypto taxes so you can keep more of your money and maximize your gains. To do this, you first need a basic understanding of how cryptocurrency gains are taxed. Then you can start thinking about ways to reduce or eliminate your tax bill. Hopefully, the information and tips below will help you keep a lid on crypto taxes and let you get ahead financially.
What are Crypto Taxes?
Cryptocurrency is considered “property” for federal income tax purposes. And, for the typical investor, the IRS treats it as a capital asset. As a result, crypto taxes are no different than the taxes you pay on any other gain realized on the sale or exchange of a capital asset.
When you purchase a capital asset – be it a stock, bond, house, widget, Dogecoin, Bitcoin, or other investment – you establish a basis equal to your cost to acquire it. When you sell, you compare your sales proceeds to the basis to determine whether you have a capital loss or a capital gain. If your proceeds exceed your basis, you have a capital gain. If reversed, you have a capital loss.
You'll also need to consider the time period for which you held the asset. Depending on how long you hold your cryptocurrency, your gains or losses will be considered “short-term” or “long-term.” That distinction will also play a big role in how much you have to pay in crypto taxes.
- Short-Term Capital Gains and Losses. When you buy and sell an asset within a 365 day period, you recognize a short-term capital gain or loss. Short-term gains are subject to the same tax rates you pay on ordinary income, such as wages, salaries, commissions and other earned income. The IRS has seven tax brackets for ordinary income ranging from 10% to 37% in 2021.
- Long-Term Capital Gains and Losses. If you buy an asset and sell it after a year, the difference between the sales price and your basis is long-term capital gain or loss. You’ll usually pay less tax on a long-term gain than on a short-term gain because the rates are generally lower. Currently, there are three tax rates for long-term capital gains – 0%, 15%, and 20%. The rate you pay depends on your income.
How to Minimize Crypto Taxes
Now that you know a bit more about crypto taxes, which is really just another way of saying capital gains taxes, you will want a set of strategies to minimize how much you pay to the IRS. Here are some useful tips to reduce your tax bill.
1. Hold Until Your Short-Term Gains Turn Into Long-Term Gains
As just noted, different capital gains rates will apply depending on how long you own cryptocurrency. If you want to lower your tax bill, hold your cryptocurrency long enough to turn your short-term gains into long-term gains. It may not be an easy task, but if you have the patience and fortitude to keep your crypto for at least a year before selling, then you’ll likely pay a reduced tax rate on any capital gain.
Here’s an example: Mary, a single taxpayer, earns $70,000 in wages for 2021. She also has $5,000 in capital gains from the sale of cryptocurrency. If the gain is short-term gain, she’ll have $75,000 of ordinary income. After claiming the standard deduction, that leaves her with $62,450 of taxable income, which puts her in the 22% tax bracket and results in a tax bill of $9,488. However, if the gain is long-term gain, the $70,000 of ordinary income, minus the standard deduction, is still taxed in the 22% bracket, but the $5,000 of capital gain income is only taxed at 15%. That means an overall tax of $9,138 – and a savings of $350.
2. Offset Capital Gains with Capital Losses
Another strategy for lowering the taxes crypto investors must pay is to offset capital gains with capital losses. This works by subtracting losses on crypto assets that you sold during the year from taxable gains on cryptocurrencies or other investments that have appreciated in value.
Though, be warned: You face limits when using this strategy. When you recognize investment losses, you first must offset losses of the same type. For example, short-term losses first reduce your short-term gains while long-term losses lower your long-term gains.
After that, if you have net losses of either type, you can use them to offset the other kind of capital gain. So, for example, if you have excess short-term losses, you can apply them against any remaining long-term capital gain.
If you still have a net capital loss available, you can use it to lower your ordinary income. However, when pursuing this strategy, you can only use up to $3,000 of capital loss to lower your ordinary income in any given year. The remaining balance rolls forward to the following year to offset future gains or lower your ordinary income by up to $3,000.
3. Sell In a Low-Income Year
When waiting for your crypto gains to convert from short- to long-term, you might also consider another timing element: Choosing to sell in a low-income year.
Selling in a low-income year can help with taxes on both short-term and long-term gains. If you have short-term gains, which are taxed as ordinary income, you won’t have as much other income added on that pushes you into a higher tax bracket. For example, if you sell short-term assets when you retire and are no longer collecting wages, your tax bracket could be based entirely on the income from your short-term gains. If you have long-term capital gains, a lower overall income for the year can mean a lower tax rate on those gains, too. That’s because the long-term capital gains rate that applies to you – either 0%, 15% or 20% – is based on your taxable income. So, if you have less taxable income, you’re more likely to have a lower longer-term capital gains tax rate.
Also, if you choose to retire early and have accumulated enough cash to fund your living expenses until you can withdraw funds from your retirement accounts, you might have little-to-no-income during the year. If so, this is a perfect time to lock in long-term capital gains and possibly pay a 0% tax rate.
4. Reduce Your Taxable Income
Closely related to selling your appreciated investments in a low-income year, another tried-and-true tax minimization strategy involves lowering your taxable income. This means scouring the tax code for tax deductions and credits that can bring your taxable income down.
For example, you can take care of expensive medical procedures, contribute to a traditional IRA or 401(k) plan, put money in a health savings account, or donate cash or property to charity. There are plenty of other tax deductions and credits that you may qualify for, too. You might even want to ask a tax professional to help you uncover some other tax breaks.
5. Invest in Crypto in a Self-Directed Individual Retirement Account
Another strategy to minimize your crypto tax bill includes investing in a tax-deferred or tax-free Self-Directed Individual Retirement Account (SDIRA). That way, you either pay taxes later when you conceivably have a lower taxable income in retirement or upfront when you contribute to your Roth SDIRA because you have expectations of higher taxes in retirement.
6. Gift the Assets to a Family Member
Depending on your goals for using your wealth, you might consider another way of lowering your crypto tax bill: Gifting your cryptocurrency to family members.
The IRS allows you to gift up to $15,000 per year per person without tax consequences. While the basis in the cryptocurrency transfers to the new owner, the recipient might earn a low enough income where they won't pay taxes on the appreciated property when sold. Or, at the very least, less in taxes than you might have to pay were you to sell the cryptocurrency yourself.
This strategy certainly plays into your broader estate planning goals and how you wish to transfer your wealth. That also makes it something that you should first discuss with an estate planner to ensure that it fits in with your overall plan.
7. Donate Your Appreciated Cryptocurrency to Charity
Similar to gifting appreciated crypto to a family member, you might also think about donating your cryptocurrency to charity. Not only will this result in no capital gains tax, it can also trigger a significant tax deduction you can claim on your tax return.
When you donate an asset, you can claim the appreciated fair market value at the time of donation as a deduction against your taxable income. For example, if you own $50,000 worth of Bitcoin and choose to donate it to a charity you regularly support, you may be able to write this off as a charitable deduction on your return. Further, if the charitable organization qualifies as a tax exempt 501(c)(3) charity, it won't need to pay capital gains taxes when it sells the donated cryptocurrency later.
8. Move to a State with No Income Tax
Forgotten in this article – until now – are state-level income taxes. Not surprisingly, your state has a vested interest in your investment gains as well.
Fortunately, a number of tax-friendly states offer low or no income taxes. That means you might pay taxes at the federal level, but you won't owe much to your state's treasury.
If you can, consider moving to a low- or no-income tax state to reduce or even wipe-out taxes on all types of income. These savings can add up and help you keep more of your crypto-earnings.
9. Bequeath it in Your Estate
The final crypto tax minimization strategy on this list is to bequeath your crypto assets as part of your estate. When you pass away, the investment will receive a “step up” (i.e., increase) in basis to its fair market value at the time of your death. This way, your heirs will not need to pay taxes based on your original basis when they sell the cryptocurrency they inherited.
However, because cryptocurrencies carry significant volatility, depending on the virtual currencies you owned, they could shoot up (or down) at a moment's notice. If this happens and the virtual currencies go to the moon, at least your heirs' tax bill won't be as large since they received the tokens with a stepped up basis.