Growing interest and investment in Bitcoin and other cryptocurrencies can create tax-reporting challenges for entrepreneurs and small investors. But you can avoid unnecessary taxes and get tax benefits by taking proper steps.
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This year saw the introduction of new words into the financial lexicon of many casual investors and small business owners. It seems like you couldn’t click on a web article or social media site and not see something about Dogecoin, NFTs, Hodl, Ethereum, Coinbase and of course Bitcoin. While these terms, and what they each mean, might be new to casual investors, they are certainly not new to the IRS as the U.S. tax agency is focusing more resources and effort toward securing crypto taxes.
During testimony before the Senate Finance Committee last month, IRS Commissioner Charles Rettig stated that the U.S. government fails to collect as much as $1 trillion in revenue every year due in part to recent exponential growth and interest in cryptocurrencies.
According to CoinGecko the entire cryptocurrency category has a market cap of $2.3 trillion. Bitcoin is nearly half that amount on its own, making it more valuable than Disney, Home Depot and Exxon combined.
Those types of numbers have drawn IRS attention and enforcement actions. In March, federal officials arrested six individuals in New Hampshire for alleged money laundering and tax evasion involving e-currencies. Last November, IRS agents were able to track down multiple cryptocurrency accounts on the Dark Web resulting in the seizure of $1 billion in digital assets – the largest cryptocurrency capture to date.
And the IRS is not just targeting criminals. In 2019, the agency issued a “reminder” to individual tax filers to voluntarily report past cryptocurrency transactions.
“In 2017, which was a very high-growth year for cryptocurrencies, prices went up tremendously and then dropped significantly in 2018. I saw taxpayers that had massive taxable gains in 2017 and then lost their entire portfolio the next year. Now the IRS is calling, and those individuals still must pay taxes on those earlier gains, but they don’t have the funds. Proper planning and tax optimization services can help prevent that,” according to Justin Woodward, a tax attorney who specializes in digital assets and is the co-founder of TaxBit.
Wooward offers these five cryptocurrency tax tips to help plan for current and future tax seasons:
- The IRS currently classifies cryptocurrencies as “property” not securities. As such, that asset class is taxed at the short- or long-term capital gains rate depending on how long you’ve held an asset. “If you hold a cryptocurrency for a year or less, the short-term tax rate for 2020 ranges from 10 to 37 percent depending on income and filing status. If you hold a digital asset for longer than a year the long-term tax rate applies, ranging from zero to 20 percent on profits,” said Woodward.
- Another important consideration is understanding that you’re not taxed only when you convert your cryptocurrencies back into fiat currencies such as dollars or euros. “Taxable events can occur even if you swap a crypto asset for another token including stable coins such as USDC or DAI. A key determinate of the taxable amount for each transaction will depend on your initial cost basis, which was how much you initially paid for each respective token versus its price at disposition when you sold or converted into something else,” he said.
- Woodward also noted that as with most assets, initially acquiring any given digital token is not usually a taxable event, neither is moving tokens to a different crypto exchange such as Coinbase or a digital wallet; however, disposition of a token at a loss or profit is a taxable event in most circumstances. “Also, if someone sends you a digital asset in exchange for a product or service or you earn interest in the form of a cryptocurrency those are taxable the same way interest earned on traditional securities would be taxed,” he noted.
- When it comes to tax minimization tactics, cryptocurrencies can be excellent tools to easily “harvest losses” if you’re a high-income earner looking for some write-offs. Volatility is an inherent attribute of cryptocurrencies and smart investors can use that to their benefit. When wide swings happen, it’s extremely wise to take a lose if you can. “Say you have one Bitcoin that drops $5,000 in a day. You can legally exchange that for a stable coin or any other cryptocurrency and then immediately buy back that same Bitcoin within minutes. There is no repurchase waiting period as with other securities. This is a tremendous way to intentionally harvest losses by documenting the initial loss while also lowering your cost basis on the repurchase.”
- Lastly, and perhaps most importantly, tracking the tax impact of your cryptocurrency trades can be easier and safer than you think. Linking the exchanges where you make transactions and crypto wallets to some of the newer crypto-focused tax tracking software can fully automate the process for both individual investors and businesses — even for transactions dating back to 2014. Woodward noted that under recent tax changes, past losses can be carried forward indefinitely until they are fully claimed.
He added that if this is your first year dealing with the tax implications for cryptocurrencies, it’s best to seek expert help by contacting a tax preparer or accountant with experience in digital assets – but don’t wait. “Many people mistakenly believe that taxes are completed only once a year, but it requires vigilance all year long especially when you’re invested in cryptocurrencies. Once you file taxes for 2020, don’t wait for the last minute next year – begin planning for 2021 now,” said Wooward.