Did you buy, sell, or exchange cryptocurrency over the past year? If so, you may owe capital gains tax. The exact amount of tax you owe depends on many factors, including the amount of time you held the cryptocurrency. Understanding the capital gains tax rate is essential to minimize the amount of tax you pay each year.
Let's take a look at long-term vs. short-term capital gains and how you can minimize your crypto tax bill.
What is a Capital Gain On Crypto?
Before we get to understanding the differences between long-term vs short-term capital gain on crypto, let’s first understand what is a capital gain. Capital gains are profits that you make from selling a cryptocurrency—or any other asset for that matter. When you sell a digital asset like crypto for more than you paid to buy it, you must report that capital gain to the IRS on your income taxes. The amount of capital gains tax you owe depends on the holding period (as we'll see) and your income tax bracket.
Capital gains taxes apply to all kinds of cryptocurrency transactions. For example, an investor that lends USDC on BlockFi and earns 8.6% interest must pay capital gains tax on the accumulated interest. Similarly, a crypto miner that mines one Bitcoin per year must pay income tax on the Bitcoin and capital gains tax if they sell the Bitcoin for U.S. dollars.
At the end of each year, the IRS allows you to match your capital gains and losses to determine your net capital gain or loss. You can use up to $3,000 in net capital losses to offset your other taxable income, and any additional losses can be carried forward into future years to offset either capital gains or up to $3,000 per year in ordinary income.
Note: There are no capital gains or losses in retirement accounts, such as IRAs or 401(k)s. As a result, you cannot use losses in these accounts to offset gains or other income.
What Are Capital Losses?
Virtually everything you own can be called a capital asset. You earn capital gains after selling an asset over a certain period of time. However, there’s a chance that you will incur losses when you sell an asset. These are called capital losses and it is the money you’ve lost via an investment or an asset.
However, it’s not all bad. Capital losses can be used to lower your overall tax bill by offsetting the gains. You can determine the amount of taxes by computing your net gains or losses. If you have more losses than gains, you can subtract the difference on your tax return, which is up to $3,000 a year.
Understanding Long-Term vs Short-Term Capital Gains for Crypto Taxation
1. Short-Term Capital Gains Tax on Cryptocurrency
Short-term gains occur when you buy, sell, or exchange crypto assets within one year. The holding period begins from the day you acquire the cryptocurrency and lasts up to (and includes) the day you sell it.
So, how much is the short-term capital gains tax on cryptocurrency? The specific amount depends on your marginal tax rate, which changes each year.
The 2021 marginal tax rates are:
Tax-deferred retirement accounts typically pay short-term capital gains tax rates upon withdrawal. For example, if you buy cryptocurrencies in a traditional IRA, you receive an immediate tax deduction and don't have to pay any tax until withdrawing the money. However, you typically pay short-term capital gains tax on these withdrawals.
2. Long-term Capital Gains Gains Tax on Cryptocurrency
Long-term capital gains occur when you buy, sell, or exchange crypto assets after one year. Again, the holding period begins the day you acquire the asset and ends the day you sell it.
So, how much is the long-term capital gains tax on cryptocurrency? The specific amount depends on your income tax bracket, but low earners could pay nothing while high earners could save as much as 17% off their ordinary tax rate.
The 2021 long-term capital gains tax rates are:
In the bout of short-term vs. long-term capital gains tax, long-term capital gains tax is again a clear winner.
What Are The Capital Gains Tax Exemptions on Cryptocurrency?
Capital gains taxes apply to most asset sales, but there are a couple of exceptions to the rules—including one that applies to a popular class of cryptocurrencies!
Collectible assets, such as collector cars and fine wines, are subject to a 28% collectibles tax rate regardless of the holding period. Unfortunately, non-fungible tokens (NFTs) tend to fall into this category. Therefore, Crypto traders and investors should keep these higher tax rates in mind when buying and selling NFTs in their portfolios.
The Net Investment Income Tax (NIIT) adds a 3.8% surcharge to certain investments held by individuals, estates, and trusts. These taxes apply to individuals with a modified adjusted gross income of more than $200,000 for individuals or $250,000 for married couples filing jointly. The tax is calculated, reported, and filed on Form 8960.
Of course, states may also have capital gains tax rates separate from the federal rates. For example, New York's long-term capital gains tax rates can reach up to 31.5%, consisting of a 20% national and 11.5% state rate.
After looking at the two types of capital gains, let’s look at what triggers a capital gains tax event:
- Selling crypto: It is the most common capital gains tax event. This event is triggered when you sell your crypto tokens for fiat currency. For instance, if you bought 2 Bitcoins for $10,000 and then after six months decided to sell them for $15,000, you will be taxed for a short-term capital gain of $5,000. The same goes if you sell after holding it for a year (long-term capital gains tax).
- Using crypto to buy goods and services: If you buy any goods or services with your cryptocurrency, it will be subject to a capital gain. For example, you bought one Bitcoin for $500 and after 3 years the value of the same token is $20,000. Now, you bought a car using the same token. You’ll incur a long-term capital gain of $19,500.
- Exchanging one crypto for another: Exchanging tokens is also a taxable event. Let’s say you bought 10 AAVE for $2000. After some time, you traded it for ETH, but at the time of exchange, the value of AAVE reached $5000. So, you’ve incurred a capital gain of $3,000 and you have to report this income.
Handy Checklist of Crypto Tax Saving Strategies
You can use several strategies to minimize your tax exposure, ranging from simply holding assets longer to implementing complex strategies.
The most widespread strategies include:
- Hold cryptocurrencies for more than one year. You can pay long-term capital gains tax rates by keeping cryptocurrencies for more than a year before selling them.
- Invest in tax-free or tax-deferred accounts. You could avoid capital gains taxes altogether or delay them by investing in Roth IRAs, 401(k)s, and other tax-advantaged accounts.
- Harvest your tax losses throughout the year. Tax-loss harvesting involves selling losing positions to realize a capital loss in the current year and then replacing them in your portfolio.
- Choose the proper accounting methods. The IRS lets you use FIFO, LIFO, and Minimization methods to adjust the holding periods for tax lots. Choosing the correct technique can help you save.
ZenLedger helps aggregate transactions across multiple wallets and exchanges and automatically computes your capital gains and losses. In addition, the platform makes it easy to implement strategies like tax-loss harvesting to minimize your taxes each year.
The Bottom Line
Crypto traders and investors should always keep in mind long-term versus short-term capital gains taxes. Using the strategies we've covered and a platform like ZenLedger, you can minimize your tax bill each year and avoid any problems with the IRS.