Forbes recently estimated that approximately $25 million in taxes is owed by Americans that in one way or another used cryptocurrency in 2017. During this period, cryptocurrencies such as Bitcoin skyrocketed to valuations as high as $19,000 – which meant that a lot of crypto traders got very rich, very fast. It also meant that IRS finally began paying serious attention to cryptocurrencies.
There have been numerous reports around the world of crypto traders being taxed on profits they never actually made, and forums like reddit are buzzing with taxpayers in desperate need of help. In this article we will go over some of the things traders need to be aware of to avoid falling into tax-debt.
Familiarize yourself with the basics of crypto taxation
Knowledge is key – the old saying holds true even for crypto taxes. After all, if you don’t know the rules surrounding cryptocurrency taxes – how can you not end up indebted to the IRS? So, let’s look at some of the things every crypto trader should know about taxes.
Record all your transactions
The IRS treats cryptocurrencies as ‘property’ which means you have to report capital gains on your transactions. Whenever you dispose of cryptocurrency by selling or trading, you will need to report the gains. You don’t need to report anything if you are simply buying to HODL.
Even when you are paying for goods / services
Have you ever paid for something with bitcoin? Like a starbucks coffee or perhaps a netflix subscription? Those are all taxable events and have to be reported! Even though this may seem counter-intuitive, the IRS has made it clear that any disposal of cryptocurrency is to be treated as a taxable event. Unfortunately, ignorance of the law is not freedom from the law so you are advised to always keep records of such transactions.
Don’t trust tax reports from Coinbase, Poloniex and other exchanges
Some cryptocurrency exchanges will evaluate your records and even estimate what you owe to the IRS, however the tax reporting from a single exchange is incomplete if you have traded on multiple exchanges and can result in over-paying on taxes.
For ex. If you have transferred funds from one exchange to another, the receiving exchange has no way of knowing the cost-basis or purchase price of those assets and will incorrectly treat the deposit as a purchase of crypto at market rate.
The IRS is already on the hunt
Some crypto investors are still fixated on the original appeal of cryptocurrency which was to operate outside the control of the state and financial regulators. However, remember that data that links you to your crypto-assets is available to the IRS as well so it is not worth the risk of penalties. Just recently, the IRS started sending out warning letters to crypto owners who had either completely neglected their crypto taxes or had declared them incorrectly. There are special rules for transactions like forks, airdrops, gifts and margin trading which can make them difficult to declare so it is advisable to refer to an up-to-date tax guide or consult a professional.
Harvest your unrealized-losses before the year ends
Tax Loss Harvesting is a strategy that comes in handy when your crypto holdings have decreased in value but you made some gains earlier in the year. All you have to do is sell your reduced-in-value crypto so that you realize a loss and then simply buy them back right after!
While this may sound dubious, it is a common practise and has existed for as long as there have been exchanges. If you trade on stock markets you have probably heard of the ‘Wash-sale rule’ that was enacted to combat this method of tax avoidance. In a nutshell the wash sale rule prevents superficial losses like this if you buy back the assets within 30 days of the sale. The good news for crypto traders is that this rule does not apply to cryptocurrencies which are classified by IRS, as property.
Claim upto $3,000 in tax-free income if you ended the year with a loss
IRS asserts that if your total capital gains and losses for the year add up to a negative figure, you have incurred a net capital loss. If that’s the case, you can get a tax-rebate of up to $3,000 on your income to offset some of your losses. If the amount exceeds this cap, it can be used in the following year as well.
Need fast cash? Take out a crypto loan!
Loans are not taxed by the IRS because you are not disposing of any assets, you are simply borrowing against them. If you find yourself in need of some fiat, this is a pretty solid way of avoiding capital gains.
Keep in mind that if your collateral gets liquidated, you will incur capital gains. Also, if you are paying interest with crypto currency – that is also a capital gain.
If you are in the crypto lending space you have probably heard of the DAI token which is basically a stablecoin (meaning it’s value is always $1). It should be noted that while technically DAI is a loan against ETH – it is unlikely that IRS would view it as such due to the highly technical nature of the transaction. It is therefore recommended that you treat any transactions involving DAI as taxable trades.
Avoid trading or selling in the first year
Capital gains are taxed differently depending on how long you held the assets for. If you hold for a year, your gains will be taxed as long-term capital gains which are taxed at 0, 15 or 20% (depending on income bracket). If you sell within the first year you will incur short term capital gains which are taxed at your regular income bracket which is generally higher than the long-term brackets.
If you dare: Specific Identification
Specific Identification allows you to cherry-pick the assets that you are selling which allows for some pretty advanced tax strategies. It is used in conjunction with either FIFO or LIFO to determine the cost-basis of an asset. Essentially, Spec ID allows you to group your assets into ‘lots’ and apply FIFO or LIFO to the lots instead of applying them universally – as long as you can ‘adequately identify’ the lots that you are selling from.
For ex. with Bitcoin, you generally receive crypto in a new address every time, so if you note the cost-basis for each transaction, you could pick the transaction that is most beneficial to you when trading/sending crypto and thus avoid realizing excessive capital gains. While this does require a lot of extra effort the upside is less taxes.
It should be noted that there hasn’t been any guidance from the IRS on whether this rule can be applied to cryptocurrencies. So, if you decide to use Spec Id, you may have to redo all your tax reports if the IRS releases guidance against it!
Put aside 30% of your profits for tax
When you have run out of options to reduce your taxes it is best to start saving up. A good rule of thumb is to put aside around 30% of your profits for tax purposes. Generally, you will pay less tax on assets held for more than a year. So, depending on your trading style you can adjust the figure to suit your needs.
If you lost your crypto to hacks / theft…
As part of the Tax Cuts And Jobs Act , losses attained due to theft, robbery or hacks cannot be used to reduce your capital gains. The only way to get a tax-break in such circumstances is if the loss is attributable to a nationally declared disaster, which is unlikely to ever be the case with crypto-related losses. So, if your exchange admin died under mysterious circumstances, you are pretty much out of luck.
The bottom line is that crypto investors that take an active role in managing their crypto taxes can easily mitigate accidental tax debts. Do not wait until the last minute to do your taxes, the time to make a difference is long-gone by then. Be proactive and you will not only stay safe but even minimize the amount of tax you have to pay.
For those that are considering trading cryptocurrency, the take-away here is to keep detailed records of your transactions, use some of the tax-saving strategies you have learnt here and most importantly take time to understand the tax implications of crypto trading.
This is a guest editorial by Robin Singh, the CEO and founder of Koinly.io – a cryptocurrency tax platform that generates compliant capital gains reports for a number of countries like the US, Ireland and Canada.