Every year taxpayers throughout the United States collect and record their earnings and report them to the IRS. While three-quarters of taxpayers receive refunds, the stress associated with collecting year-end tax documents and receipts from employers, financial institutions and others is often enough to cause anxiety.
These feelings are amplified for many cryptocurrency users, traders and investors. After adding a crypto question on Form 1040, it’s clear that the IRS is ramping up efforts to collect taxes on the digital assets, although its guidance has been confusing at best. Many taxpayers are worried about correctly reporting crypto income on their returns.
Let’s take a look at how you can prepare for tax season as a crypto trader or investor, as well as some tips to help simplify your life.
A Brief Crypto Tax Primer
The IRS treats cryptocurrencies as property, which makes them more like a stock than a currency, from a tax standpoint. Taxpayers are required to report any capital gains or losses from cryptocurrency transactions—including commercial transactions (e.g., buying a cup of coffee with Bitcoin)—and pay tax on any net capital gains for the year.
There are a few important considerations:
- The cost basis is the amount that you paid to acquire the crypto asset in U.S. dollars. If you bought one cryptocurrency with another cryptocurrency, you must determine the value of the transaction in U.S. dollars at the time it took place.
- The capital gain or loss is the difference between the cost basis and the sale proceeds in U.S. dollar terms (e.g., a transaction with a $20 cost basis and $100 in sale proceeds results in a $75 capital gain).
- The amount of capital gains tax that you owe depends on your tax bracket and holding time. If you held a crypto asset for more than one year before selling it, you are subject to long-term capital gains tax rates. Assets held for less than a year are subject to higher short-term capital gains tax rates equivalent to ordinary income tax brackets.
- Capital gains and losses are reported on IRS Form 1040 Schedule D and Form 8949.
ZenLedger and other crypto tax software is the easiest way to aggregate transactions, compute capital gains and losses and accurately fill out tax forms. In addition to simplifying these processes, crypto tax software can help you identify ways to reduce taxes through tax loss harvesting and provide a defensible audit trail in the event of any IRS questions.
Crypto Tax Checklist
Tax season is a stressful time for anyone. In addition to organizing year-end tax forms, traders and investors must make a number of year-end decisions to optimize their taxes, such as recharacterizing IRA contributions or realizing unrealized losses. The lack of guidance from the IRS on some critical crypto issues compounds these stress levels.
You can prepare for tax time by gathering some key items:
- List your crypto exchanges and wallets: Many crypto traders and investors hold assets across different exchanges and wallets. When determining cost basis, you must consider transactions from all sources, so it helps to come prepared with a list of exchanges and wallets that you’ve used during the year for reconciliation.
- Record any crypto received as income: Those earning crypto as income should have a detailed record of how much they received and when they received it. In addition to employers, other sources of income might be crypto mining or DeFi platforms that pay out interest in the form of crypto.
- List any crypto donations: Donations made in cryptocurrencies are deductible in the same way as stocks. In addition to writing off the value of the donation, you don’t have to pay taxes on any capital gains accrued over time. Keep a record of donations to ensure that you benefit from both of these factors.
- Save receipts from airdrops and forks: Airdrops and forks have their own unique tax implications and it’s important to ensure that you have an accurate source of income for cost basis calculations.
- Record any crypto received as a gift: Most gifts are not taxable but there’s no way to easily distinguish gifts from any other crypto transaction when looking at your records. By recording gifts, you can ensure that you’re not paying tax on them.
- Gather IRS Forms Schedule D and 8949: Most taxpayers only have to report crypto taxes on IRS Form 1040 Schedule D and Form 8949. In addition, you must disclose that you’ve transacted in cryptocurrencies at the top of Form 1040. Additional forms and disclosures may be required if you have international accounts.
The IRS also recommends that you keep specific records of transactions:
- The date and time that each cryptocurrency was acquired.
- The basis and fair market value of each cryptocurrency at the time it was acquired.
- The date and time each cryptocurrency was sold, exchanged or disposed of.
- The fair market value of each cryptocurrency when sold, exchanged or disposed of and the amount of money or the value of property received for each cryptocurrency.
While these records are critical within each tax season, you should maintain a record of them for at least six years in case the IRS goes back to audit past tax returns. Many exchanges keep customer records on file, but they could shut down at any time, so it’s important to download backup transaction records or store them with dedicated crypto tax software.
Tax Savings Tips
Many crypto users, traders and investors have realized significant gains. In fact, that’s the very reason that the IRS is so interested in enforcing payment! The good news is that there are several fully-legal strategies that you can use to reduce your tax burden while remaining on the IRS’ good side and minimizing your audit risk.
The best ways to reduce crypto taxes include:
- Increase your holding time: Capital gains tax rates are lower for assets that were held for more than a year than those held for less than a year.
- Use the right accounting method: The accounting method that you use (e.g., FIFO, LIFO, etc.) can have a significant impact on your tax rates. In general, FIFO has the lowest tax rates because you’re selling your oldest positions first.
- Harvest loss for tax purposes: Tax loss harvesting involves selling unrealized losses in order to recognize the loss in the current tax year and then replacing the cryptocurrency in your portfolio in order to reduce your current year tax burden.
- Donate crypto: Cryptocurrency donations aren’t subject to capital gains tax and you can write off the entire value of the donation. It can be a great way to support a cause that you love while reducing your tax burden.
The Bottom Line
Tax season is a stressful time for many Americans, but crypto users, traders and investors may have even greater anxiety. With the IRS cracking down on the space, it has never been more important to ensure that you accurately prepare your taxes, although that doesn’t mean that you should leave opportunities to reduce your tax burden on the table.