Being a successful investor in cryptocurrency is very stressful - you need to keep up with news about the projects you invest in, macroeconomic news, and political news just to try to keep an edge in the markets. It is difficult enough to make a profit when investing or trading; the last thing you want is to volunteer more than what you should fairly pay to the IRS for taxes. Unlike other types of income, such as wages or investments in traditional securities, you will not generally receive a tax form for taxable events from your crypto trading. You must calculate your crypto gains yourself, leaving room for error and potentially overpaying your taxes. With so many pitfalls where a crypto investor can overpay their taxes, it is critical to understand how crypto is taxed while having some strategies to minimize your crypto tax bill when you file your next income tax return.

First Things First, How is Crypto Taxed?

Cryptocurrency taxation for individual taxpayers in the United States primarily consists of capital gains and losses from trading and selling crypto assets and ordinary income from staking, mining, yield farming, airdrops, or any other income-generating activity. 

Ordinary Income

Receiving cryptocurrency as income triggers an immediate tax obligation. This includes a variety of scenarios, such as mining, staking, earning interest in crypto savings accounts, receiving airdrops, or getting paid in cryptocurrency for services rendered. In each of these instances, the value of the cryptocurrency at the time it becomes accessible to you forms the basis of the income to be reported on your tax return. It's essential to accurately track and report these transactions since the IRS considers them taxable events. They are taxable based on the asset's fair market value (USD) when the taxpayer obtains control.

Capital Gains Tax on Cryptocurrency

For tax purposes, the IRS views cryptocurrency as property. This classification means that you're liable for capital gains tax on the profit whenever you sell, trade, or use cryptocurrency in a transaction where its value has appreciated since you acquired it. This tax is calculated based on the difference between the sale price and your original cost basis - the initial price you paid for the crypto, including any associated transaction fees or additional costs incurred in the acquisition.

Capital gains on cryptocurrencies are categorized into short-term and long-term, based on how long you've held the asset before selling or trading it. Short-term capital gains are applicable to assets held for less than a year and are taxed at your regular income tax rate, while long-term capital gains from assets held for more than a year benefit from lower tax rates. The distinction between these two types of gains is crucial as it significantly impacts your tax liability.

Now that you understand how crypto is taxed. Let’s minimize our capital gains and ordinary income tax liability from crypto investments.

Invest for the Long Term

This one is relatively straightforward as most of us are aware that by holding onto an investment for at least a year before selling, any gains will be taxed at the long-term preferential tax rates of 0%, 15%, or 20%, always a lower rate than short-term capital gains, taxed between 10% to 37% depending on your tax bracket. By waiting until an asset reaches the one-year mark before selling, you will save significant taxes from any gain you incur. 

This sounds easy in principle - avoid selling any short-term assets while selling only long-term ones. However, this can become tricky due to a highly volatile market such as the crypto market. For example, suppose you buy PEPE at just the right time and see it go up an astounding 1000% weekly. Surely, PEPE could be on its way to becoming the next trillion-dollar asset, but in all likelihood, the whales will be looking to dump after such a pump. You could hold onto your PEPE that is up 1000% and wait for the tokens to become long-term, but you risk watching it dump. Paying a higher tax rate on higher gains is always better than paying a much lower rate on a much smaller amount. Always consider the tax impact relative to the fundamentals of the underlying investment.

Another complicating factor for crypto investors is knowing each asset's holding period. Crypto investors who trade on multiple exchanges and are involved with DeFi may have difficulty keeping a clear breakdown of their holdings and acquisition data for each. While blockchain explorers and exchanges do keep track of transaction data, due to transfers and different tax methods, an investor can’t just use this data to know which coins are long vs short-term. Therefore, savvy investors rely on crypto tax software - tools that help you create your tax reports. Many of them have the functionality to show you the holding period of each coin - often within their tax loss harvesting tool.

2024 Tax Rates - Ordinary Income & Short-Term Capital Gains

2024 Tax Rates - Long-Term Capital Gains

Tax Loss Harvesting - Sell Your Losers

Tax loss harvesting involves strategically selling crypto assets at a loss to offset capital gains from other investments or other crypto assets. For example, suppose an investor realizes a significant gain from a cryptocurrency like Bitcoin. In that case, they can sell another crypto, such as Ethereum, that has depreciated relative to their purchase price to balance the gain. This approach effectively reduces the overall tax liability by converting market downturns into tax-saving opportunities. 

Tax loss harvesting requires the investor to proactively track his crypto portfolio cost basis to know whether he has opportunities to harvest some losses - positions where the fair market value is less than the taxpayer’s acquisition cost. In addition, the investor should know their year-to-date taxable gains. While this may seem pretty straightforward - simply track the price of an asset relative to your purchase price, things can quickly become complicated for investors using multiple exchanges, trading multiple currencies, trading high volume, and generating recurring income, which impacts the tax basis. For that reason, we recommend using crypto tax software.

An additional layer of complexity comes from the unique regulatory stance on cryptocurrencies concerning the wash sale rule. This rule, familiar in the stock market, does not currently apply to crypto assets. An investor can technically sell a cryptocurrency at a loss for tax benefits and quickly repurchase it, maintaining their investment position while securing a tax advantage. However, this will likely change soon as regulators have repeatedly considered closing this loophole for crypto investors. Check out our Tax Loss Harvesting blog post for more information.

Understand Your Investments and Tax Options

While the United States is making a lot of progress in regulating digital assets, we are still in the Wild West regarding taxation and reporting of crypto relative to stocks and other securities. While the tax principles for gains and losses are relatively straightforward (outside of subtle modalities such as a disposal method - FIFO, LIFO, HIFO), many transactions within the crypto ecosystem have yet to see guidance from legislators and tax authorities. Things like liquidity pools, rebasing cryptocurrencies, and even staking, which, despite the guidance under Revenue Ruling 2023-14, the Jarrets continue to litigate, arguing that income should not be recognized upon receipt of staking rewards but rather upon disposing of those rewards. Depending on how you treat these transactions for tax, your tax liability could look very different.

If you are engaging in complex crypto transactions, you must understand the tax law and opposing viewpoints. We recommend consulting with a professional to manage the risk properly.

Diligently Review Crypto Tax Reports

This is one of the most overlooked manners in which crypto taxpayers can reduce their tax liability without taking any tax positions or using any tax strategies. Crypto tax software is necessary for every crypto investor unless you are only buying and holding (and even then, it is recommended so you can adequately track the tax basis); however, due to a plethora of industry-wide issues, without a diligent eye, the reports can substantially overstate your tax liability.

Duplicate transactions, missing cost basis, missing data, missing exchanges, and even time zone discrepancies can significantly cause your tax reports to overstate your gains. This is why it is essential to constantly review your results once you run the numbers and turn yourself into a forensic crypto accountant to figure out where the data gaps occurred. Spending a few hours with your tool of choice, finding the issues, and fixing them could save you thousands of dollars that you would have paid just for insufficient data. Contact our team for a free consultation if you need help figuring out where to start.

Report All Crypto Losses

The nice thing about U.S. tax law is that it allows you to deduct your capital losses. Other jurisdictions worldwide do not allow taxpayers a deduction for their losses (while still taxing their gains) - but fortunately, this is not the case for the American tax system. If you are a crypto investor and have lost money in the crypto market, you can deduct any realized crypto losses.

Calculating crypto losses can be very difficult and time-consuming. When you consider the multiple tools and data challenges (as outlined in the previous paragraph) combined with exchanges leaving the US or doing rug-pulls making obtaining the data even more challenging, as well as unclear tax rules, this creates complexity that can lead to taxpayers not understanding what their actual losses are, or choosing not to report their losses that they are by law allowed to deduct. Consider an investor who lost $250,000 in FTX. Even if you can only deduct a net capital loss of $3,000 each tax year, not reporting this would effectively mean that you will be overpaying on your gains on a $250,000 tax base.

Plan Sales for Lower Income Years

Different tax rates apply depending on your income in the United States. Long-term capital gain rates are 0%, 15%, or 20%,  while ordinary and short-term rates are 10% to 37%. The higher your taxable income in a given year, the higher the tax rates you will pay in both short and long-term gains.

While only some taxpayers may be able to manage their income, there are situations in which this is possible. Whether it’s due to the loss of a job, retirement, or perhaps you are a business owner who can manage their taxable income, if your income varies from year to year, it would be wise to consider selling appreciated investments in years of lower income. Regardless, similar to the PEPE example above, you must consider the economics of the investment first. Do not hold onto a bad asset because you are waiting for the right tax year. However, if you have good assets that you believe in for the long term, it may be beneficial to plan when to liquidate your investments.

Maximize Retirement Contributions

There are two sides to this equation: the overall impact that this will have on your taxable income and the opportunity to invest in crypto through a retirement account where you could actively trade without worrying about capital gains tax.

Maximizing your contributions to your 401(k) or IRA is a good idea to minimize your tax liability, as you can deduct these contributions from your taxable income. Remember, this will not be the case with a Roth plan, which uses after-tax dollars but yields tax-free distributions to the extent of the contributed basis into the plans. However, with traditional IRAs and 401(k)’s, you can deduct these from your taxable income, thus reducing your overall tax liability.

Many investors considering Bitcoin and other crypto assets as long-term investments have explored purchasing these inside retirement accounts. Several providers can facilitate setting up a retirement account with cryptocurrency. If you do this, any trades within the account (exchanging Bitcoin for Ethereum, for example) will not be subject to capital gains tax, thus allowing you to make the most out of swing trades. Remember, however, that any funds you contribute to a retirement account will not be available until you reach 59 ½ years of age. If you need the funds before then, be ready to pay a steep 10% early withdrawal penalty on top of federal and state taxes - meaning that you could see up to a 50% combined tax rate on early distributions.

Conclusion

You don’t have to become a tax wizard to be able to optimize your crypto taxes. Whether through diligent review of your reports or strategic planning to harvest all your crypto losses, spending a few minutes understanding how each of these strategies works and proactively applying them as part of your overall financial plan can help you save a significant amount of money on your tax bill.