Most crypto traders and investors try to make as much as possible, but what really matters is how much you keep after taxes. In fact, the amount lost to taxes and other costs is a crucial factor influencing returns. Fortunately, you have more control over your taxes than you might think, and with some planning, you can hold on to more of your returns.
Let's look at five strategies to reduce your crypto tax liabilities.
Taxes significantly impact overall profitability, so it's essential to implement tax-efficient strategies.
How Crypto Taxes Work
The IRS considers cryptocurrencies property for tax purposes, meaning you owe tax on any capital gains. In addition to paying taxes when converting a cryptocurrency to U.S. dollars, you owe tax on conversions between two cryptocurrencies. In these cases, you must determine the cost basis and fair market value in U.S. dollars to compute your tax obligations.
While simple conversions are straightforward, more complex crypto transactions or exotic tokens have unclear tax consequences. For instance, non-fungible tokens (NFTs) may be considered "collectibles," making them subject to a higher collectibles tax rate. And the taxation of liquidity pools remains a gray area without much specific IRS guidance.
The easiest way to calculate and pay taxes on cryptocurrency transactions is using crypto tax software, like ZenLedger. Rather than trying to manually reconcile transactions or trust exchanges, the platform aggregates transactions across all of your wallets and exchanges and matches them up to compute an accurate capital gain or loss.
While crypto tax software ensures accuracy, these solutions don’t necessarily help you create tax-efficient portfolios. There are several strategies that you can use to offset or defer capital gains taxes or even eliminate them.
#1. Harvest Losses
Tax-loss harvesting reduces your net capital gains and, as a result, your tax bill for the financial year. While the strategy sounds complex, it's really very simple: You sell positions with an unrealized loss and repurchase them shortly after to retain your asset allocations. By selling the position, you realize a tax loss that you can write off on your taxes.
Unlike equities, tax loss harvesting isn't subject to the Wash Sale Rule, so you don't have to wait 30 days before repurchasing it. However, a conservative interpretation of the IRS tax law suggests that there must be a meaningful economic change in the price of the cryptocurrency before you replace it, so it's a good idea to wait at least a day or two.
#2. Invest for the Long-Term
The IRS considers cryptocurrencies property, meaning you owe capital gains tax on any sale–even if you're not receiving U.S. dollars. However, the tax rate you pay depends on how long you've held the position. If you hold it for more than one year before selling, you pay a lower long-term capital gains tax rate rather than your marginal income tax rate.
While you should never avoid selling a cryptocurrency just to reduce your tax rate, you might wait a little longer if you're a long-term investor on the fence about when to take profits off the table. Or, more generally, you might change your approach from being a short-term trader to a long-term investor to minimize the impact of taxes.
#3. Take Profits in Low-Income Years
The U.S. has a progressive tax system where those earning more income pay a higher percentage of that income in taxes. So if you have flexibility in selling cryptocurrencies, selling during a low-income year at a lower tax rate could help you save a bundle. For instance, if you earn less than $41,675, you wouldn't pay any long-term capital gains tax.
Low income years don’t necessarily mean earning less income from a job, either. In some cases, you may have large one-off expenses that you can use when itemizing to lower your taxable income. However, the standard deduction stands at $12,950 for single filers and $25,900 for married filers filing jointly in 2022.
#4. Donate or Gift Cryptocurrencies
Donating cryptocurrencies to charity enables you to avoid capital gains taxes altogether. If you itemize your tax return, you can deduct these donations from your taxable income and reduce your overall tax liability. And even better, 501(c)3 non-profits don't have to pay any capital gains tax, so your entire donation goes directly to causes important to you.
You can also avoid paying capital gains taxes by gifting cryptocurrencies to a friend or family member. While receiving a gift isn't a taxable event, the recipient will owe taxes on any appreciation from the time of receipt. The good news is that the cost basis resets to the price at the time of receipt, meaning both parties avoid any prior capital gain.
#5. Use an IRA or 401(k) Account
Conventional retirement accounts cannot hold cryptocurrencies, but there are a handful of workarounds for those looking for tax-advantaged accounts. While retirement accounts can help dramatically reduce tax liability, you cannot access the money until you reach a certain age, and some accounts have fees and other costs to consider.
Self-directed IRAs (SDIRAs) enable you to purchase alternative investments – including cryptocurrencies – within an IRA account. Coin IRA, iTrust Shares, and other companies specialize in setting up these accounts with a focus on cryptocurrencies. However, you should carefully vet these companies since they're less regulated than typical brokers.
The Bottom Line
Tax-efficient strategies can help dramatically increase the amount of profits you keep after paying taxes. In addition to these strategies, you may want to consider working with an accountant that can help take a look at your entire financial situation to identify ways to reduce your tax burden across different assets and accounts.
If you're looking for a way to simplify your crypto taxes, ZenLedger's platform automatically aggregates transactions across wallets and exchanges, computes your capital gain or loss, and auto-populates the IRS forms you need each year. That way, you know you're paying exactly the right amount every time.