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I Invest in Cryptocurrencies; Can I Avoid Taxes?

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    Man's hands over a digital globe as he trades cryptocurrencies

    The IRS treats cryptocurrency as a standard type of property, the same as receiving comic books or a car. The government taxes this asset as either ordinary income or capital gains. This means that if you sell it and make a profit, you will ordinarily owe taxes on those gains. As with all investment assets, though, there are a few ways to reduce your tax liability. Here’s what you need to know. Alternative assets like cryptocurrencies are best handled with the insights and guidance of a financial advisor.

    How Crypto Is Taxed

    The IRS does not consider crypto a form of currency for any tax event. Instead, it treats cryptocurrency as property and has ruled that “general tax principles applicable to property transactions apply to transactions using virtual currency.” This means that there are no special sections or carve-outs for crypto in the tax code. If you make money using cryptocurrency, or if you accept cryptocurrency as payment, you owe taxes on those gains.

    There are two ways that you can be taxed for cryptocurrency holdings.

    Capital Gains

    If you sell your cryptocurrency and realize a gain on it, this is considered a capital gain the same as if you’d sold any other piece of property. Per the IRS: “The character of the gain or loss generally depends on whether the virtual currency is a capital asset in the hands of the taxpayer. A taxpayer generally realizes capital gain or loss on the sale or exchange of virtual currency that is a capital asset in the hands of the taxpayer. For example, stocks, bonds, and other investment property are generally capital assets.”

    Capital gains taxes are triggered whenever you sell something for more than its tax basis. The tax basis is the value of the asset at the time you received it. This means that any time you sell cryptocurrency, whether you bought it for your investment portfolio or received it in exchange for something, you can trigger capital gains taxes.

    Income, Property Gain

    When you increase your wealth through work or by selling non-investment assets, the IRS considers it a taxable gain. This is what’s known as “ordinary income.” This holds true for cryptocurrency as well. You realize an ordinary loss or gain on cryptocurrency when you receive it as payment for work or in exchange for goods and services. When you receive cryptocurrency in exchange for goods or services, you must calculate the market value of the cryptocurrency at the time you receive it. This is your taxable gain.

    This is also true if you spend cryptocurrency. If you exchange your cryptocurrency for something else of value, you trigger a taxable event that is taxed as ordinary income. In this case you would owe the IRS the difference between the value of the cryptocurrency and the value of what you exchanged it for. Again, this is the same as all property transactions.

    Ordinary income and capital gains income are taxed at two separate rates. As a general rule, capital gains taxes are considerably lower than ordinary income taxes.

    You do not need to declare a taxable gain if you purchase cryptocurrency. This is true of all property. Buying an asset is considered a net-neutral exchange. A taxable event only occurs if you sell cryptocurrency for more than you paid for it, or if you receive cryptocurrency in exchange for labor, goods or services.

    While the specifics can differ, in most cases you will be unable to avoid capital gains taxes if you own crpyto and then sell it for profit. If you bought your crypto, your gains are calculated as the difference between what you paid and what you received. If you received your crypto in exchange for goods or services, your gains are calculated as the difference between the market value of the cryptocurrency when you received it and what you made from selling it.

    You will owe ordinary income taxes if you received cryptocurrency in exchange for goods and services. In this case, your taxable status is the same as if you had exchanged any other two forms of property.

    How to Mitigate Taxes on Crypto

    Man investing in crypto assets

    There are two reasons to exercise caution while investing in cryptocurrency. First, fraud, money laundering and other illegal activities are not exactly rare in the crypto world. Second, as of early 2022 both the IRS and the SEC were still defining their approach to all forms of this asset class. This means that the IRS pays unusually close attention to cryptocurrency investments. The chances of an audit could be high. With these two cautions in mind, here are three ways to mitigate crypto taxes:

    Manage Your ‘Cash’ Flow

    If you receive cryptocurrency in exchange for goods and services, you can reduce your tax bill by managing when you receive these assets. If you take possession of cryptocurrency when its price is at a low point, you can ensure that you receive the least amount of taxable wealth. While this creates a larger tax event when you sell your cryptocurrency, capital gains taxes are lower than income taxes.

    However, this strategy does depend on predicting the movement of a volatile asset.

    You can also apply what is known as “HIFO” (“Highest In, First Out”) accounting. In this case, if you are using your cryptocurrency to make purchases or exchanges, you would track which specific tokens you use for each transaction. You try to use tokens with an original cost basis (their value when you bought or received them) as close as possible to the value of what you’re purchasing. This minimizes any gains in value, reducing your tax bill.

    For example, say you bought Token ABC for $5,000. Later on you buy Token 123 for $10,000. Their value appreciates, to the point where each is worth $20,000. Now you want to exchange one of these tokens for a new car. In either case you will owe the difference between their original purchase price and the value of this $20,000 car. If you use Token ABC, you will owe taxes on $15,000. However, if you make sure to use Token 123, you will only owe taxes on the $10,000 difference.

    Retirement Account Investments

    As an investment asset, you can include cryptocurrency in many different types of retirement accounts. You can do this either by directly purchasing crypto tokens in a qualifying portfolio, or by investing in crypto-related assets such as an asset-indexed ETF or cryptocurrency-related companies.

    In a portfolio like a 401(k) or an IRA, you can reduce your taxes by making these investments with pre-tax income. If you include cryptocurrency in a Roth IRA, however, you can eliminate your taxes on the portfolio’s gains. While you’ll make those investments with post-tax money, when you sell your cryptocurrency in retirement you’ll get to do so tax free.

    It’s important to note, however, that cryptocurrency is an extremely volatile asset class. This makes it potentially good for some portions of your portfolio, since it can post very real gains, but terrible for others, since it comes with extremely high risk and as-yet no demonstrated fundamental value. With a retirement account you want to be particularly careful of risky assets, since there’s no way to get that money back once you’ve stopped working. That’s not to say you should have no speculative assets in your IRA … just be cautious with how you balance risk and reward.

    The Wash Sale Rule

    Though the IRS considers digital currency to be property rather than a security there was, as of December 2021, no crypto wash sale rule. This means that you could sell cryptocurrency you own at a loss and repurchase the same cryptocurrency without having to observe any waiting period in between. And you could claim capital losses or capital gains on your taxes accordingly.

    But there is something of a catch. This rule applies to cryptocurrencies that are not securities. It does not, however, extend to cryptocurrency stocks or funds, of which there are several. So, say you purchased 100 shares of Coinbase (COIN), a stock that trades on the NASDAQ. You decide to sell the stock and do so at a loss. In order to harvest the loss, you wouldn’t be able to purchase a “substantially identical” crypto stock within the 30 days prior to and following the sale.

    So what does substantially identical even mean? The IRS doesn’t offer a straightforward definition. Instead, at time of writing, it’s left largely to investors to determine what substantially identical means, which can make tax-loss harvesting more challenging as there’s a lot of gray area to navigate. Talking to a financial advisor would be most advisable.

    The Bottom Line

    Magnifying glass on a PC keyboard and one key marked "CRYPTO"

    The IRS taxes cryptocurrency as ordinary property. This means that you pay capital gains taxes on any held property which you sell for cash, and ordinary income taxes on any exchanges or payments. If you manage when and how you exchange cryptocurrency you can reduce your taxes, and by including it in the high-risk section of your retirement portfolio you can do so as well.

    Tips on Investing

    • Speculative assets are your best friend in the world … right up until they aren’t. That’s why it makes a great deal of sense to work with a financial advisor as you build your portfolio (with or without crypto assets). Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

    • The federal income tax system is progressive, so the rate of taxation increases as income increases. Marginal tax rates range from 10% to 37%. Get a quick estimate of what you owe with this no-cost income tax calculator.

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    The post How to Avoid Taxes on Crypto Investments appeared first on SmartAsset Blog.


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