Algorithmic trading has become increasingly popular over the past couple of years. Since traders using these strategies typically generate a high number of transactions each year, they have more complex tax situations than conventional traders or investors that may only trade a couple hundred times per year. Fortunately, there are ways to simplify these taxes.
Let's take a look at how algorithmic traders can minimize taxes, maximize reductions and simplify the tax preparation process.
The Rise of the Algorithms
Algorithmic, or algo for short, traders leverage computers to automatically identify and execute a large number of trades based on predefined technical or liquidity-based criteria. For example, algorithms may identify opportunities to provide liquidity to earn rewards from issuers or execute complex technical analysis strategies.
Algorithmic trading has become increasingly popular over the past couple of years with the rise of consumer-friendly tools that make it easier than ever to automate trades.
- HummingBot enables anyone to earn rewards by providing liquidity to their favorite tokens. The open source project’s goal is to democratize algo trading by enabling strategies previously only available to financial institutions.
- CryptoHopper enables anyone to build and share trading strategies without writing any code. After building a strategy, you can run the strategy across more than 100 different crypto assets in just a few clicks to remove emotion from the equation.
- Collective2 enables anyone to subscribe to other people's algorithmic trading strategies. The goal is to bring verified, institutional trading strategies to the general public through an easy to use platform.
Many professional traders use algorithms to remove emotional biases in their trading and ensure that they don't miss any opportunities. Other traders rely on algorithmic trading to execute trades that last only a few seconds and/or require instant action—a difficult or impossible feat for any human trader.
Algorithmic trading is poised to become increasingly popular as new platforms lower the barrier to entry and more individuals participate in the crypto markets.
Qualified Trader or Corporation?
Algorithmic traders tend to seek a qualified trader status from the IRS or incorporate to reduce their tax liability.
Qualified traders can file a Schedule C and deduct ordinary and necessary business expenses related to their trading activity, such as equipment, subscriptions and margin interest. They can also use mark to market accounting to realize all losses in the current tax year and avoid wash sale rules.
Mark to market accounting methods assume that securities held open at the end of the year are sold at their current market value on December 31. By realizing a taxable gain or loss on the holdings, you don't have to worry about wash sales and you can deduct more than the $3,000 individual limit.
The downside of mark to market accounting methods is that traders must report unrealized gains. For example, you might be sitting on a $10,000 unrealized gain and have to pay taxes on that amount despite not earning any actual cash. The good news is that you can usually offset gains with tax loss harvesting.
If the IRS rejects qualified trader status, many algo traders incorporate their business to realize similar benefits and potentially improve their odds of becoming a qualified trader. Traders usually set up single member limited liability companies (LLCs) that pay taxes as an S-Corporation, although traders can also opt to be a C-Corporation.
If you’re a professional trader, ask your accountant about the pros and cons of qualified trader status and/or incorporation to find opportunities to reduce your tax burden.
How to Simplify Your Crypto Taxes
Crypto Taxes are challenging for many reasons. In addition to IRS ambiguities, it's challenging to calculate the cost basis for transactions that aren't settled in U.S. dollars. Crypto traders must also deal with airdrops, hard forks and other unusual transactions that could involve a large tax liability (e.g. if they have a zero cost basis).
For example, suppose that you have thousands of transactions spanning four different exchanges. If you sell Bitcoin for Ethereum on one exchange, you may need to look for the cost basis on another exchange depending on the timing. You also need to determine the fair value of both crypto assets in U.S. dollars at the time of the trade.
These calculations can be extremely challenging if you have thousands of algorithmic trades in a given month or year. If you don't have the right software tools or your exchange doesn’t provide the data, it could take many hours of sorting through transaction logs to find the necessary figures—and those could be billable hours!
The bigger issue is defending these transactions in the event of an IRS audit. With the IRS’ increasing focus on crypto traders, it’s important to be able to defend the cost basis of each transaction while minimizing the amount of time that it takes to go back through and verify transactions by hand (thereby accruing more billable hours).
ZenLedger's Drilldown into Specific Trades - Source: ZenLedger
ZenLedger makes it easy to aggregate crypto transactions across wallets and exchanges and auto-generates popular IRS forms, such as Form 8949 and Form 1040 Schedule D. In addition, you can use the platform's tax loss harvesting tool to identify opportunities to maximize your losses and drill down into each transaction to defend yourself in an audit.
The Bottom Line
Algorithmic trading has become increasingly popular over the past several years with the rise of consumer-friendly platforms. With thousands of trades per year, it can be challenging for these traders to prepare Crypto Taxes and Accounting and ensure that they have a defensible audit trail.
If you're looking to simplify your taxes, try ZenLedger's automated solutions to aggregate your transactions, pre-populate common forms and create a defensible audit trail in the process that you can use during an IRS audit.