Cryptocurrency investors are experiencing significant gains in recent years. And since cryptocurrencies are treated as property per IRS Notice 2014-21, it’s considered a capital asset. Meaning every time you sell, trade, or exchange tokens into USD and incur a gain (your proceeds exceed your costs of purchase) you are required to pay taxes on those gains.
So if you’re one of the millions who have capitalized on the cryptocurrency boom and are sitting on gains, here are five tax planning strategies you can use to legally reduce or eliminate your tax liability on those profits.
1. Hold Your Cryptocurrency Until Your Short-Term Gains Turn Into Long-Term Gains
When you buy and sell an asset within a 365-day period, it’s considered a short-term capital gain or loss. Short-term gains are subject to the same tax rates you pay on ordinary income, such as wages, salaries, commissions and other earned income. The IRS has seven tax brackets for ordinary income ranging from 10% to 37% in 2021.
However if you buy an asset and sell it after a year, the difference between the sales price and your basis is considered long-term capital gain or loss. You’ll usually pay less tax on a long-term gain than on a short-term gain because the rates lower. Currently, there are three tax rates for long-term capital gains – 0%, 15%, and 20%. The rate you pay depends on your income.
As you can see, different capital gains rates will apply depending on how long you own cryptocurrency. So if you want to lower your tax bill, hold your cryptocurrency long enough to turn your short-term gains into long-term gains. If you keep your crypto for at least a year before selling, then you’ll likely pay a reduced tax rate on any capital gain.
2. Offset Capital Gains with Capital Losses
Another strategy for lowering the taxes on cryptocurrency is to offset capital gains with capital losses. This works by subtracting losses on crypto assets that you sold during the year from taxable gains on cryptocurrencies or other investments that have appreciated in value.
There are some rules around this, though. Losses on your investments are first used to offset capital gains of the same type. So, short-term losses are first deducted against short-term gains, and long-term losses are deducted against long-term gains.
After that, if you have net losses of either type, you can use them to offset other types of gains, including ordinary income. Keep in mind, though, that when you use this strategy, you can only use up to $3,000 in any given year. If there is a remainder, it would roll forward to the following year to offset future gains or lower ordinary income.
3. Sell In a Low-Income Year
Selling in a low-income year can help with taxes on both short-term and long-term gains. If you have short-term gains, which are taxed as ordinary income, you won’t have as much other income added on that pushes you into a higher tax bracket.
For example, if you sell short-term assets when you retire and are no longer collecting wages, your tax bracket could be based entirely on the income from your short-term gains. If you have long-term capital gains, a lower overall income for the year can mean a lower tax rate on those gains, too. That’s because the long-term capital gains rate that applies to you – either 0%, 15% or 20% – is based on your taxable income. So, if you have less taxable income, you’re more likely to have a lower longer-term capital gains tax rate.
Also, if you choose to retire early and have accumulated enough cash to fund your living expenses until you can withdraw funds from your retirement accounts, you might have little-to-no-income during the year. If so, this is a perfect time to lock in long-term capital gains and possibly pay a 0% tax rate.
4. Reduce Your Taxable Income
Another common planning strategy is to lower your overall taxable income. This means applying appropriate tax deductions to bring your total income down.
For example, you can contribute to retirement accounts, put money in a health savings account, make donations to charity, or apply a number of other applicable tax deductions. You might even want to book a consultation with a tax professional like me to help you uncover some other tax breaks.
Here are several free and downloadable guides and resources that can help you with tax deductions to reduce your income.
5. Invest a Self-Directed Individual Retirement Account
Another strategy to minimize your cryptocurrency capital gains tax is to invest in a tax-deferred or tax-free Self-Directed Individual Retirement Account (SDIRA).
A self-directed IRA is an individual account which allows alternative investments for retirement savings.
By using this strategy, you have the option to defer paying the taxes at a later time when you have a lower taxable income in retirement.
This article is for informational purposes only and not intended to be legal or official tax advice. We always recommend discussing with your attorney or tax professional to determine how this information affects your specific situation.
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