In spite of its short history, the cryptocurrency market has already generated enormous riches for its early adopters. Nonetheless, each time wealth is generated, it is likely to be taxed in some form.
Fortunately, there are provisions in the U.S. tax legislation that may help crypto investors lower their tax liability. Depending on your circumstances, the following nine options may help you minimize or eliminate bitcoin tax liability.
The Fiscal Mechanisms of Virtual Currencies
U.S. citizens must pay taxes on all of their international earnings. Holding bitcoin is mostly seen as an investment by its holders. In accordance with the current virtual currency rules issued by the Internal Revenue Service (IRS), cryptocurrencies and other blockchain-based assets, such as non-fungible tokens (NFTs), are often categorized as capital assets. This implies that you will be subject to paying capital gains tax. (We also talk about how cryptocurrency may be used as a form of income in a minute.)
Capital gains are subject to taxation in a number of different ways. Depending on how long you've held the asset, in this example bitcoin, you'll either have short-term or long-term capital gains.
When an investor sells bitcoin for more than they paid for it and keeps the investment for less than a year, the profit is considered a short-term capital gain. This creates a taxable occurrence treated the same way as wage income by the taxman.
If you keep bitcoin for more than a year and sell it for more than you paid for it, you have made a long-term financial gain. Long-term capital gains are taxed at rates that are generally lower, sometimes reaching zero.
The IRS and/or Congress may revise their views on crypto taxes in the future, so it's important to keep that in mind. The existing taxation of cryptocurrencies, however, suggests the following strategies for mitigating or avoiding any tax liability that may arise.
1. Invest in cryptocurrency via your retirement account
For tax-free cryptocurrency investment, consider a self-directed individual retirement account (IRA). You may put money into your IRA in the form of stocks, mutual funds, or exchange-traded funds, among other common investment vehicles (ETFs). You may invest in precious metals, real estate, and cryptocurrency via your retirement account if you have a self-directed IRA.
First, you'll need to open a self-directed IRA that supports bitcoin investments. Before you dive in, make sure you have a firm grasp on how to make bitcoin purchases inside your selected self-directed IRA. Depending on your current tax status and the kind of IRA you form and contribute to, the tax advantages you get will be different after you have an account set up.
Contributions to a Traditional IRA may be deducted from your taxable income, but withdrawals in retirement are subject to regular income tax rates. If you qualify, your withdrawals from a Roth IRA in retirement will be completely tax-free, but you'll have to deposit after-tax dollars to the account. Check out our guide comparing Roth and regular IRAs for more details.
2. Relocate to Puerto Rico
Moving to Puerto Rico might help you avoid paying U.S. federal income tax on part of your digital asset riches. Capital gains in Puerto Rico, a U.S. territory, are completely free from taxation. If you are wanting to minimize your tax liability, whether on cryptocurrency or on capital gains from equities, relocating to Puerto Rico may be a good option.
In reality, the benefits of this approach are less than they seem at first glance. To be eligible to file your taxes in Puerto Rico, you must establish and maintain residence there. You must still pay U.S. federal income tax on any bitcoin profits you've made prior to relocating to Puerto Rico and establishing legal residence there. You should talk to a tax professional before contemplating this technique because of how difficult it is.
3. Report cryptocurrency earnings.
Cryptocurrency mining and staking are not subject to the same tax rules as conventional income. Getting paid in cryptocurrencies in these scenarios means declaring that amount as income. You must disclose the amount of bitcoin you got as income at its current market price.
This amount, once reported, is subject to taxation at the individual's standard rate. Rates like this are more expensive than those on returns from investments. The amount you include in your income tax return for bitcoin you receive is its basis, the worth it had when you first acquired it. You'll need to know your cryptocurrency's basis in order to figure out how much tax you owe when you sell it and pay the right amount of capital gains tax.
The same holds true for the process of bitcoin mining. However, bitcoin mining is often seen as a self-employed endeavor. As a result, you'll have to fork out more cash in the form of self-employment taxes in addition to the usual income taxes.
4. Keep your cryptocurrency investments for the long haul
Until you sell your cryptocurrency, you normally won't have to pay taxes on it if you're just keeping it as an investment. If you don't sell any in a particular tax year, you won't have to pay any taxes on the gain.
It's possible, however, that you'll want to unload some of your crypto holdings at some point. Make sure the cryptocurrency you sell has been in your possession for at least a year if you want to pay less in taxes when you cash it out. Depending on whether this has occurred, the sale of your cryptocurrency may be subject to the more lenient long-term capital gains tax rates. Considerable tax savings may result from doing so.
5. Balance out cryptocurrency profits and losses
Depending on the direction of the sale, a profit or loss will be recorded in the investor's account. The amount you pocket is determined by the difference between the asset's selling price and its cost basis. Gains and losses on investments may cancel each other out under the current tax system in the United States. It's termed "tax-loss harvesting" when done on purpose to reduce taxable income.
Profits and losses of the same kind are first canceled out by other gains and losses of the same type. In terms of taxes, any profits would cancel out any losses from selling anything quickly. Then, any net loss may be counterbalanced by a net gain of the opposite kind.
Here's a hypothetical portfolio breakdown: you lost $1,000 quickly, gained $2,000 quickly, made $3,000 slowly, and lost $5,000 slowly. Here, you would realize a net short-term gain of $1,000 but a long-term loss of $2,000. The final long-term loss would be $1,000 after deducting all of these values.
Your annual capital loss, if any, may be deducted up to $3,000. You may bank your remaining loss for the next year. The finest robo-advisors often provide investors with automated tax loss harvesting.
6. Reduce debt by liquidating assets in a low-income year
The tax rate you'll pay on your capital gains, whether they're short- or long-term, will depend on how much money you make. Generally speaking, your tax rate will be lower if your taxable income is smaller. You might potentially reduce your tax liability by selling bitcoin in the year you expect it to appreciate, if that year has a lower tax rate than the year you expect to pay taxes.
However, contrary to popular belief, increasing your income by selling bitcoin does not automatically put you in a higher tax category.
7. Give to a good cause
If you itemize your deductions and give to a charity that meets certain requirements, your donation may be eligible for a tax credit. You need to have owned the asset for a year before making the donation.
If you donate anything of value, like bitcoin, you may be eligible for a tax deduction. The current market value of your bitcoin holdings may be deducted without incurring any capital gains tax.
If you think making a contribution might improve your tax status, you should talk to an accountant about the limits on the deduction amount.
8. Provide your loved ones with presents
To minimize or eliminate tax liability on bitcoin profits, consider making a gift of it. There will be no gift tax due, either from the receiver or the giver. You do not need to file a gift tax return or pay any gift taxes if your annual gifts to any one recipient do not exceed $15,000. If your lifetime inheritance is worth less than $11.7 million, you may give away as much as you want without worrying about gift taxes, even if you go above the $15,000 threshold.
Your bitcoin receiver will need to know your basis in the cryptocurrency in order to calculate their own tax liability when they sell the cryptocurrency. Any profit made beyond your base will be subject to taxation, however it's possible that their rate may be lower than yours.
A person in their fifties who has built a successful career is more likely to be in a higher tax rate than a twenty something with a first job. In this case, the recipient may have a lower tax bill on the cryptocurrency if you give it to a younger relative.
9. Retain it till the end of time (no matter how long that takes)
Cryptocurrency may be used as a means to develop wealth for future generations if the funds are not immediately needed. You need to have faith in the long-term worth of a cryptocurrency for this method to be successful, but it might result in preferential tax treatment.
Following your passing, your heirs will get an increased basis in the assets you leave them. For the sake of argument, let's imagine you spent $1,000 on bitcoin (BTC) today and it increased in value to $250,000 by the time of your death 20 years from now. Selling the bitcoins immediately before passing away would result in a $249,000 profit that would be subject to taxes.
In the event of your passing and the bitcoin's subsequent transfer to your beneficiaries, the basis will grow from $1,000 to the $250,000 it is worth at that time. If the asset's basis is identical to its selling price, your heirs won't owe any capital gains tax when they sell the property.
Consult an expert in estate planning if you want to ensure that your inheritance is handled appropriately.
To sum up
If you invest money in crypto assets before they start going up in value, you may realize large returns. A little forethought may go a long way toward minimizing the crypto tax you'll owe on your winnings if you're so fortunate. When consulting a tax expert, you may find the above list of suggestions useful.
Don't forget that the tax treatment of cryptocurrencies is exceedingly complicated, and that the ramifications may even evolve in the future. That's why it's smart to get the advice of a tax attorney or CPA (CPA). They may make sure you're in compliance with all tax regulations and assist you reduce your tax liability.