Many early investors in Bitcoin and other cryptocurrencies have made millions of dollars, but they may also owe hundreds of thousands of dollars in taxes. With the IRS cracking down on crypto tax evasion, it's more important than ever to ensure that you're current on your taxes. Fortunately, there are several ways to reduce your tax burden.
Crypto like-kind exchanges enable investors to defer capital gains taxes on crypto-to-crypto transactions. While the 2017 Tax Cuts and Jobs Act restricted like-kind exchanges to real estate, transactions before 2018 could still be eligible for like-kind exchange status, which can significantly lower your tax bill, depending on your circumstances.
Let's take a look at 1031 Like-Kind Exchanges, why they matter in the crypto world, and what they mean for you.
What is a 1031 Exchange?
Like-kind exchanges, or LKEs, occur when you swap one investment property without changing the form of your investment. In other words, you're exchanging very similar property without cashing out. IRS Section 1031 lets you defer the payment of capital gains taxes on these transactions, given that you do not realize a tangible profit.
The term is most common in the real estate world, where developers will roll over gains from one deal to another. While you may profit with each swap, you don't have to pay taxes until you sell for cash years down the road. You can then pay a single long-term capital gains tax on the proceeds when liquidating the final property for cash.
1031 Like-Kind Exchanges & Cryptocurrency
Since the IRS considers cryptocurrencies "property," Section 1031 Like-Kind Exchanges theoretically apply to them. Moreover, IRS Notice 2014-21 classified all cryptocurrencies as "convertible virtual currencies," satisfying the requirement that exchanged property be "of one kind of class" to qualify under the rules of Section 1031.
There are two key benefits of a 1031 Exchange:
- You don't owe taxes on gains that you subsequently give up. For instance, if you make a $5,000 gain on BTC, exchange it for ETH, and later lose $2,500, you only owe capital gains tax on the $2,500 gain and avoid tax on the original $5,000 gain. You also benefit from the time value of the money you would have paid in tax.
- You can minimize exposure to short-term capital gains tax rates (e.g., your marginal tax rate) and pay primarily lower long-term capital gains tax rates. That's because you don't have to reset the clock every time you make a transaction. The long-term capital gains tax rate (typically 15%) kicks in after one year.
However, in December 2017, Congress passed the Tax Cuts and Jobs Act, which modified Section 1031, limiting like-kind exchanges to real estate. While you can no longer make like-kind exchanges for cryptocurrency transactions, the law doesn't apply to transactions that occurred before the tax year 2018, meaning you could still have overpaid taxes.
Crypto Like-Kind Exchanges in 2021: Amending Past Returns
Section 1031 Like-Kind Exchanges could help crypto traders and investors save money on crypto-to-crypto trades made before 2018. In particular, there may be an opportunity to recover large amounts of cash by amending your tax return. However, you should consult an experienced crypto tax accountant or attorney before amending your returns.
Suppose that you bought ten Bitcoins on February 1, 2017, for $1,000. In December, you exchanged the 10 BTC for 500 Litecoin at a fair market value of around $160,000. The price of LTC subsequently falls before you sell it for $15,000 in December of 2018. Besides this depressing decline, you may be on the hook for a painful amount of taxes.
Without an LKE, you would owe around $50,000 in taxes upon exchanging BTC for LTC—the short-term capital gains tax at your marginal tax rate. While you would realize a $145,000 loss on LTC, there's a $3,000 limit on capital loss deductions in any given year, meaning that you'd have to carry forward the losses for several years.
Under an LKE, you could avoid paying any taxes with the exchange of BTC to LTC and pay long-term capital gains taxes at the 15% tax rate on the net gain of $14,000. In addition to paying a lower long-term capital gains tax rate, you aren't hit with one-time taxes and limited to claiming carry forward losses over several years.
Alternative Ways to Reduce Cryptocurrency Taxes
Crypto like-kind exchanges may not be permitted anymore, but there are many other ways to reduce your crypto tax burden.
The easiest way to reduce crypto taxes is to hold positions for more than one year. That way, you qualify for the long-term capital gains tax rate (typically 15%) rather than the short-term capital gains tax rate that's equivalent to your marginal tax rate. In many cases, you can cut your tax burden in half, saving a significant amount of money.
The correct accounting method makes it easy to hold positions longer and qualify for lower long-term capital gains tax rates. For instance, last-in-first-out (LIFO) is a bad idea since you're matching the last purchase with your most recent sale, while first-in-first-out (FIFO) matches your earliest purchase with your most recent sale, extending the timeframe.
Tax-loss harvesting is another way to reduce your tax burden. If you have an unrealized loss, you can sell the crypto to realize the loss in the current tax year. The loss can offset other capital gains and up to $3,000 in ordinary income and carry it forward. Since the Wash Sale Rule doesn't apply, you can replace the crypto in your portfolio.
Crypto tax software can help you track crypto transactions, compute capital gains and losses, and auto-fill popular IRS forms. That way, you can avoid accidentally overpaying or underpaying in a way that accrues penalties and interest. In addition, you can use our tax-loss harvesting tool to identify opportunities within your portfolio.
The Bottom Line
Crypto like-kind exchanges aren't allowed anymore following the 2017 Tax Cuts and Jobs Act, but you may still be able to amend prior tax returns to take advantage of LKEs. At the same time, there are various other ways that you can reduce your crypto taxes over time, from increasing your holding time to harvesting tax losses.
It's always a good idea to seek the advice of a knowledgeable crypto tax accountant or lawyer, particularly if you plan to amend past returns. In addition to avoiding costly mistakes, accountants can take a holistic look at your financial assets and find the best ways to optimize them to reduce your tax burden over the long term.
ZenLedger can help you accurately file your taxes while minimizing your tax burden.