Crypto trading has been a lucrative source of income for some, but do you know that it can cause tax liabilities as well?
In order to ensure that you get to pay as little tax as possible, you need to plan ahead and prepare. Otherwise, you might end up with debt instead of profits. Moreover, failure to pay on time makes investors liable to IRS penalties, resulting in more losses if not jail time.
In this article we will look at some strategies to avoid tax debt as well as minimize tax liabilities.
Sell instead of HODLing when you are on the losing side
Your capital gain is calculated by subtracting the cost of your cryptocurrency from its selling price. However, if you sold your coin for less than the cost of acquiring it, that is a capital loss.
Tax loss harvesting is a technique for reducing taxable gains by realizing losses. Since capital losses are fully deductible against your capital gains, they can be used to offset any gains made earlier in the year. You can even use losses to offset gains made from other types of investments such as stocks, bonds, ETFs, real estate etc.
Understandably, most crypto investors don’t like selling at a loss. The good thing is you can buy back your cryptocurrencies right after, so this technique will not necessarily affect your trading strategy. The wash-sale rule that applies to securities does not apply to cryptocurrencies.
Let’s look at an example
If you bought $10,000 worth of Bitcoin in November 2017 and traded it with Ethereum in January 2018, you would have gained $5,000 in profit, thus holding $15,000 worth of ETH. This trade is a taxable event and incurs a capital gains tax of $5,000.
Now let’s say by December 2018 you’re still holding your ETH, which has fallen in value from $15,000 to $3,000. Yet you still need to pay your capital gains tax for the $5,000 even if you’re already at a loss. Now, you have a tax liability.
Fortunately, you can turn things around thanks to tax loss harvesting. If you sell your ETH for $3,000, a capital loss of $12,000 ($3,000 sale price minus $15,000 purchase price) is generated. Now, you no longer need to pay tax since your net gain is negative! Note that you still need to file your crypto taxes.
Borrow instead of selling when you need cash
HODLing is well and good but if you truly need money, you might be forced to sell your crypto holdings. Remember, selling crypto for fiat realizes capital gains and is a taxable event. Luckily, there is a better alternative for getting money without selling your cryptocurrency, and it’s called crypto lending.
There are many different platforms offering this type of service such as Cred, CoinLoan, BlockFi. You simply give them your crypto as collateral and they will give you fiat money that you can spend freely. The catch is you have to pay high interest rates of around 12%, but this is still quite low compared to the tax rates that you would be subjected to if you had sold.
For people who prefer to keep their crypto safe and away from the grips of third-party unregulated companies, there is, fortunately, an alternative. MakerDAO launched a platform back in 2017 which allows you to lock up your crypto collateral in a smart contract (CDPs) and receive DAI in exchange for it. DAI is a stablecoin pegged to the US Dollar so you can exchange it for fiat on any exchange.
Deduct All Your Trading Fees
Trading cryptocurrencies is usually associated with extra costs like trading fees and brokerage commissions. Be sure to add up all these costs to your purchase price when calculating your cost basis. That way, you get taxed less.
Note that transfer fees are a grey area, as such costs are not directly associated with the cost of acquiring the assets, so it is not known if the IRS will allow them in your cost-basis. It is best to err on the side of caution and deduct only trading/brokerage fees. Transfer fees are comparatively quite low anyway.
HODL for at least 1 year
Capital gains are taxed differently depending on how long you have held the assets for. If you sell your holdings within a year of purchasing – you will incur short-term capital gains which are taxed at your regular income tax bracket. However, if you hold for at least a year, the assets will be taxed as long-term capital gains which are generally lower than the income tax rates.
Set Aside a Percentage of Your Gains
You should keep your taxes in mind whenever you make gains on your trades. If you don’t, the tendency is you might spend it all before paying your tax dues or the asset might drop in value so much that you can no longer pay.
It is important to set aside a certain percentage of your profits to avoid tax debt. The percent of gains to save should depend on your taxable income and filing status. Generally, 30% is a good figure to aim for.
“’Tis impossible to be sure of anything but Death and Taxes”
—The Cobbler of Preston by Christopher Bullock (1716)
We might not be able to escape taxes, but at the very least, we could minimize our tax obligations and avoid debt. The best way of doing so is by educating yourself, learn everything there is to know about crypto taxes and be proactive. If you think you can do something about your taxes a day before your return is due – you are in for a huge surprise. If you are in a sticky tax situation it might even be worth hiring a tax professional who can point the best way forward.
On a more positive note, the fact that the government taxes crypto is a testament to their willingness to accept it as a legitimate source of income.
Community contribution by Robin Singh, co-founder and CEO of Koinly.io – a cryptocurrency accountancy and tax reporting platform that simplifies capital gains reporting in US, Australia, Ireland and many other countries.