Taxes are a notoriously complex subject, with over 70,000 pages of rules and regulations. Unfortunately, cryptocurrencies are an emerging technology that only complicates the situation. But despite the complexity and ambiguity, everyone is required by law to file taxes and pay what they owe to avoid federal penalties.
Let's look at how cryptocurrency taxes work, why record keeping is essential, new 2022 tax brackets, and strategies you can use to reduce your tax liabilities.
The IRS continues to crack down on crypto despite its ambiguous rules and regulations – here's what you need to know to avoid problems in 2022 and 2023.
Crypto Taxes 101
The IRS treats cryptocurrencies as property, subjecting them to capital gains taxes. So, for example, if you use $1,000 to purchase one ETH and sell the ETH for $1,200 in six months, you will owe short-term capital gains taxes on the $200 profit. Notably, you still owe capital gains taxes if you convert ETH to BTC or use ETH to buy a coffee.
However, there are several edge cases where the agency's guidance is less clear. For instance, if you sell a non-fungible token (NFT) representing a piece of art, it's unclear whether you must pay capital gains tax or the higher collectibles tax. And, even if you're just minting an NFT, you will inevitably owe taxes on the gas fees you spend!
Even more complex scenarios arise in the decentralized finance (DeFi) space. For example, posting collateral for a loan is not typically a taxable event. However, receiving your collateral back as a different coin than the one you deposited may be taxable. And interest earned by depositing coins into a lender's wallet is also taxable.
Despite the remaining ambiguities, the IRS has become increasingly aggressive in pursuing crypto tax dodgers. For example, the agency added a question to the top of Form 1040, forcing everyone to disclose their crypto holdings. Meanwhile, it continues to subpoena exchanges and hire forensic blockchain experts to audit blockchain transactions.
Track Your Activity
Accurate record keeping is essential to avoid problems with the IRS. While most stock brokers provide year-end tax forms, you might trade cryptocurrencies across different wallets and exchanges, making it impossible for them to compute your capital gain or loss. As a result, you need to reconcile these transactions each year.
Fortunately, ZenLedger and other crypto tax software solutions can help automate the process by connecting to various wallets and exchanges and reconciling the data. That way, you don't have to merge different spreadsheets to match purchases in one business with sales in another company to compute your capital gain or loss.
When evaluating different crypto tax solutions, you should determine your requirements to find the best fit. For instance, many solutions only support a handful of exchange APIs or DeFi protocols. Others may not provide the data export capabilities you need to defend yourself in an IRS audit (e.g., they may be a "black box").
ZenLedger supports an industry-leading number of wallets, exchanges, and protocols, while computing taxes for NFT and DeFi transactions. In addition, the platform offers Grand Unified Accounting, which provides you with the evidence you need to defend yourself in the event of an audit. And best of all, you can get started for free!
2022 Tax Rates & Deadlines
The amount of tax you owe depends on several factors, including your income and the nature of your transactions. While most people cannot control their income, you may control how long you hold on to a cryptocurrency before selling it. And that length of time determines whether you pay the short-term or lower long-term capital gain rates.
The 2022 ordinary tax income rates for joint filers are:
In addition to capital gains taxes, you may owe ordinary income tax on other crypto-related activities. For instance, crypto miners must pay ordinary income tax on the value of any mined coins and capital gains taxes on any appreciation in those coins. In addition, any crypto received from staking or lending income may also be subject to tax.
Most taxpayers don't have to worry about their 2022 taxes until April of 2023, but the October 17, 2022 deadline applies to those that filed extensions in 2021 (they're due!). In addition, certain retirement account contributions for 2021 are due by October 17, 2022, including self-directed IRA reclassifications and contributions.
The good news is that there are several strategies you can use to reduce your tax liabilities. In particular, the crypto winter means that many investors can leverage tax-loss harvesting and optimize their account methods to minimize losses. And these small actions can make a big difference on your bottom line.
Some tax strategies to consider include:
- Tax-loss Harvesting – Most stocks fall under the Wash Sale Rule, making them ineligible for tax loss harvesting. However, most experts agree that you can harvest crypto tax losses by selling losing positions to lock in the loss in the current tax year and then repurchasing the cryptocurrency to reset the cost basis.
- Long-term Investing – The long-term capital gains tax rate is significantly lower than the short-term capital gains tax rate – especially for higher-income individuals. As a result, you can minimize your tax liability by simply holding cryptocurrencies for more than one year before selling or exchanging them.
- Accounting Methods – The accounting method you choose could influence your tax liability. Generally, in rising markets, LIFO (last-in, first-out) will lead to lower taxable gains. And in falling markets, FIFO (first-in, first-out) will yield better results. You can also use HIFO (highest-in, first-out) to lower your tax liabilities.
In addition to these strategies, it's always a good idea to work with a CPA or accountant capable of optimizing your entire portfolio. These professionals can help ensure you don't miss any deductions, identify synergies between different assets, and take other measures to help you avoid taxes and defend yourself in an audit.
The Bottom Line
Tax season doesn't begin and end in April – it's a year-round effort to accurately record transactions, meet different filing deadlines, and ensure that you're on the right side of the law. Fortunately, ZenLedger can help with record keeping and a series of tax strategies can help you minimize what you owe and prepare a defense for any audits. Sign up today!