Most people don’t think about taxes until January—or worse, mid-April. While taxes are only filed once per year, there are countless opportunities throughout the year to lower your tax bill. A failure to take these actions—particularly before December 31—can mean significantly higher taxes and a missed opportunity to avoid overpaying the government.
Let’s take a look at four tips on how to potentially avoid crypto taxes this year, including actions that you can take throughout the year!
IRS Enforcement of Crypto Taxes
Anyone that sells, converts, pays, donates, or earns income with cryptocurrency must report those transactions to the IRS. While it’s called cryptocurrency, the government considers the digital currency property. That means crypto’s treated more like collectible coins than dollars, and you owe tax on any increase in value between the purchase and sale price.
The tax rules are fairly straightforward on the surface: Taxpayers must calculate the difference between the purchase and selling price of a cryptocurrency and pay tax on any short or long-term capital gains. Of course, you can also use any losses to offset other capital gains or some ordinary income, so it’s worth remembering that the sword cuts both ways.
The confusion comes into play with unusual transactions, such as airdrops or hard forks. In some of these edge cases, cryptocurrency holders may be forced into paying a tax on cryptocurrency that they acquire without their permission! Many people also forget that purchases with cryptocurrency are taxed—even on a cup of coffee.
While the IRS has tried to clarify some of these edge cases, it has also made it abundantly clear that every cryptocurrency seller must pay their fair share of taxes. The agency has sent out numerous warning letters, added a new question to Form 1040, and even hired crypto experts in its efforts to track down tax evaders.
Here are the top four tips on how to potentially avoid taxes on crypto:
#1: Harvest Your Crypto Tax Losses
The easiest answer to how to avoid crypto taxes is harvesting your tax losses. While the term sounds complex, it simply involves selling an open position at a loss in order to realize that loss and then re-establishing the position. The transaction has little to no impact on your overall portfolio since the security was replaced—but it generates a tax loss for the year.
The realized loss can offset any capital gains for the tax year—including capital gains accrued in separate stock portfolios, realized losses can offset up to $3,000 of ordinary income or may be carried forward to future years. Unlike the stock market, there is no Wash Sale Rule that prevents you from replacing a recently sold asset with the exact same asset in your portfolio.
The easiest way to identify these opportunities is using automated software, such as ZenLedger’s Tax Loss Harvesting tool, which can quickly determine what opportunities are worthwhile in your portfolio and suggest specific trades. If you have a sizable portfolio, these software solutions can quickly pay for themselves in tax savings.
#2: Choose Individual vs. LLC
Those that professionally trade, mine, or earn crypto may want to consider incorporating rather than recognizing income as a sole proprietor. While the incorporation process can be complex and costly, businesses can write off qualified expenses, classify revenue in different ways, and even pay owners using different strategies in order to minimize tax.
Cryptocurrency miners that incorporate can write off the costs of hardware, electricity, and other expenses in order to offset their income. Since mining activity is classified as ordinary income, these deductions can be invaluable for reducing tax exposure. Active traders can also deduct education expenses, margin interest, and other trading-related expenses.
Active traders that incorporate can also maximize the impact of their tax losses. While individual traders can only deduct $3,000 worth of losses from ordinary income, businesses can deduct all of the losses in the year that they occur. Miners that acquire cryptocurrency at a high price and sell at a lower price can similarly fully offset their losses in the current year.
#3: Become a HODLR
Cryptocurrencies are subject to capital gains taxes, but the capital gains tax rate depends on a variety of factors. For example, short-term capital gains tax rates tend to be higher than long-term capital gains tax rates—particularly for individuals in high-income tax brackets.
Suppose that you earn $100,000 per year as a single filer. If you had $10,000 in short-term gains from cryptocurrency trading, you would pay a short-term capital gains tax rate of 24% or roughly $2,400 in taxes. If you held that cryptocurrency for over a year, your long-term capital gains tax rate would be just 15% and you’d pay only $1,500 in taxes—a $900 savings.
Even if you aren’t a long-term investor, you can optimize your capital gains tax rates by using the right accounting method. First-in-first-out, or FIFO, is typically the preferred standard accounting method since it sells the longest-held cryptocurrencies, but you can also use strategies that, for example, sell the highest price cryptocurrency first to minimize taxable gains.
#4: Use Crypto Tax Software
Many cryptocurrency traders have hundreds of thousands of transactions each year and calculating the cost basis for those transactions can be challenging. In addition, they may have transactions across multiple wallets or exchanges that must be reconciled. These reconciliations take a lot of time to do by hand or accrue a lot of billable hours if outsourced.
ZenLedger simplifies the process by connecting with different wallets and exchanges, aggregating transactions into a single place, and calculating your capital gains and losses. You can even pre-fill popular IRS forms or integrate with TurboTax to streamline the process. The result is a lot of time saved, zero errors, and significantly lower tax prep costs. If you experience an IRS audit, the platform can quickly generate defensible documentation and transparent insight into how the calculations were made. You can be sure that you’re not under or overpaying while easily defending your decisions in the event of an audit—and you don’t have to worry about potential human error.
The Bottom Line
Most people only file taxes once per year, but there are opportunities to save all year. Using ZenLedger, you can understand how to potentially avoid taxes on crypto by identifying tax-loss harvesting opportunities throughout the year in order to lower your tax bill, as well as ensure accurate returns. You should also meet with an accountant to determine the best accounting method and corporate entity for your situation.