Trading and Investing

4 Biggest Tax Mistakes Crypto Traders Make

Published
December 7, 2020
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    Crypto has become increasingly popular among active traders due to its significant volatility compared to the equity and forex markets. While the same technical analysis rules apply, there are several unique differences between crypto and conventional financial markets—particularly when it comes to calculating and paying taxes.

    Let’s take a look at the four biggest tax mistakes that crypto traders make and how they can avoid them.

    #1. Day Trading without Experience

    A popular paper published in the Journal of Finance in 2000, Trading is Hazardous to Your Wealth, found that active traders underperform the market by 6.5% per year compared to just 1.5% among investors. While the crypto market differs from equity markets, there is an innate tendency to sell winners too early and hold on to losers too long.

    In addition to psychological hurdles, successful day traders tend to be very active, which creates its own challenges. Crypto investors must calculate the cost basis for each transaction in order to calculate their year-end capital gains or losses. These calculations can be challenging across multiple wallets and exchanges while consuming countless billable hours.

    There’s also a meaningful difference between short and long-term capital gains tax rates. Long-term investors that hold crypto assets for greater than a year pay the lower capital gains tax rate whereas short-term traders that buy and sell assets within a year pay the higher ordinary income tax rates—which can take a significant cut out of trading profits.

    #2. Not Harvesting Tax Losses

    Swing and position traders may hold crypto assets for weeks or months. With the significant volatility in most crypto markets, it’s not uncommon for a position to be significantly underwater before making a comeback and ultimately a profit. These dynamics make tax loss harvesting a viable strategy for crypto traders to reduce their tax liability.

    In the equity market, most traders don’t use tax-loss harvesting because of the limited volatility and Wash Sale Rule. Traders cannot sell and repurchase the same stock to realize a tax loss without waiting at least 30 days—and that’s usually a dealbreaker for traders. The crypto market—as of now—doesn’t have any such rule to limit tax loss harvesting trades.

    Tax Loss Harvesting Platform

    ZenLedger’s Tax Loss Harvesting Tool – Source: ZenLedger

    The easiest way to find tax-loss harvesting opportunities in your portfolio is using automated tools, such as ZenLedger’s tax-loss harvesting tool, which summarizes unrealized losses across different exchanges and wallets by accounting method. In addition, you may want to talk with an accountant to determine the best tax-loss harvesting process for your portfolio.

    #3. Not Marking to Market

    Professional traders can choose to use mark-to-market rules if they make an election under IRS Revenue Code Section 475(f). In order to qualify, the IRS requires that you seek to profit from daily market movements rather than dividends, interest, or capital appreciation with substantial activity that is carried on with continuity and regularity.

    The benefit of mark-to-market accounting is that traders can treat gains and losses from sales of securities as ordinary gains and losses. For example, there are no limitations on capital losses, and wash sales rules don’t apply (in equity markets). Qualified business expenses can also be deducted from profits to help offset trading profits.

    If you don’t qualify for section 475(f), you can realize similar benefits by incorporating as an S-Corp, C-Corp, or LLC. Corporations enable you to deduct qualified business expenses and treat trading activity as ordinary gains and losses. The downside is that there is a greater level of paperwork and expenses, as well as potential double taxation.

    #4. Not Filing Crypto Taxes at All

    Many crypto enthusiasts were originally drawn to the promise of a privacy-focused digital currency free from government interference. While crypto has proven difficult to trace, that doesn’t mean crypto traders should ignore their tax liability. The IRS has made substantial investments in tracking down tax evaders—even hiring blockchain experts.

    The good news is that tax software has made it easier than ever to prepare your taxes. Using ZenLedger, you can aggregate transactions across exchanges and wallets, calculate your capital gain or loss, and even pre-fill popular IRS forms. If you use TurboTax, you can even import your tax information to reduce your accounting expenses. Try it today!

    If you failed to pay taxes in the past, it’s a good idea to file an amended return and make payments as quickly as possible. The IRS is able to offer payment plans and other options to those that struggle to pay taxes. A failure to make an on-time payment can result in fines and interest on the amount due, which can be substantial if tax evasion is discovered years later.

    The Bottom Line

    Crypto trading has become increasingly popular over the past few years and a growing number of sophisticated traders are entering the market. Given the many differences with the equity markets, both novice and advanced traders should keep the four common mistakes covered above in mind when trading in order to minimize their tax exposure.

    Fortunately, tax software has made it easy to automate a lot of the cost basis and capital gains calculations, as well as provide an audit trail in the event of any IRS questions. You can even use many of these solutions to identify ways to save on taxes through tax-loss harvesting and other strategies.

    If you’re a crypto trader, sign up for ZenLedger today to streamline your taxes and identify tax-loss harvesting opportunities.

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