There are two main types of cryptocurrency: decentralized and centralized. Cryptocurrency like Bitcoin, Ethereum, Ripple, Monero, and Litecoin are all decentralized. They have no central authority, meaning no one person or company has control over the creation of new money. Decentralized cryptocurrencies are also better known as alternative currencies, which for lack of a better term, means they are not controlled by governments or other central authorities
Every year, millions of people across the globe report their income and pay their tax liability. Many say they are unable to understand how their taxation is calculated, and how it makes them better off. Cryptocurrency, an innovative form of digital currency, has been gaining attention among the public for its potential to disrupt the financial system. Cryptocurrency is a decentralized means of storing, managing and transferring value. Cryptocurrency has been compared to digital gold, yet unlike gold, it is not regulated by any central bank, and it cannot be confiscated by a government. However, the IRS has not yet ruled on cryptocurrency as a form of property, therefore if you are using it for a business, you may be required to pay capital gains tax.
Investing and trading in cryptocurrencies can be very lucrative, and the Internal Revenue Service (IRS) has recognized this reality.
After a seemingly amazing rise in 2017, with bitcoin going from a few hundred dollars to over $20,000, the price of bitcoin plummeted and eventually settled around $2,000.
In 2021, the price of bitcoin shot up again and almost reached the $60,000 mark. Many other cryptocurrencies have also experienced similar fluctuations over the same period.
But just like any other investment, you have to pay taxes on the amount you earn. However, that doesn’t mean you have to lose all your crypto income to the US government.
There are many ways to save taxes by trading cryptocurrencies. In this article, I’ll tell you how to minimize taxes on cryptocurrencies, the easiest way to file taxes as a cryptocurrency investor, and a few other important things you should know when trading cryptocurrencies.
But first, what does buying cryptocurrencies actually mean?
What happens after you buy a crypto currency
When you buy a cryptocurrency like Ethereum or Bitcoin, you are essentially buying a digital asset that you can spend, sell at a profit, or store. These digital coins are protected by cryptography, which is essentially a unique code that protects each coin and allows it to function.
Most are based on decentralized computer networks called blockchain.
The blockchain acts as a digital ledger in which every transaction on the network is recorded infinitely. This makes it virtually impossible to counterfeit cryptocurrencies or issue them twice, as each currency has its own unique code.
Many people, including myself, believe that these virtual currencies will one day replace fiat currencies as the medium for most transactions. Cryptocurrencies still have many hurdles to overcome before they become so widespread, but it seems only a matter of time before cryptocurrencies become a legal form of payment worldwide.
No one knows exactly when this transition will occur, and every investor has a different idea of how cryptocurrencies will perform in the coming years.
Such speculation caused the prices of cryptocurrencies to skyrocket, only to fall sharply.
In 2016, a single bitcoin was only worth about $200, but by 2021, the price had almost passed the $60,000 mark. And as I write this, Bitcoin is worth about $34,000 each.
The two main strategies commonly used by cryptocurrency investors are:
- Buy, sell: This strategy is also applicable to traditional investments, such as stocks. This means that cryptocurrencies are bought at low prices and resold at a profit.
- Hold: This is probably the easiest and most lucrative way to invest in cryptocurrencies. You find a coin you believe in, buy a bunch of them and hope that one day the prices will skyrocket. Anyone who has held almost any cryptocurrency since 2016 has seen their investments grow significantly. I highly recommend this strategy to new investors in cryptocurrency.
If you are one of the many investors who have taken a big hit in cryptocurrencies, Uncle Sam says you owe him a piece of that action.
The IRS classifies cryptocurrencies as property because they are intangible assets that a person can own and grow in value. Classifying cryptocurrencies as assets also makes it easier for the government to tax them.
All gains on your investments are subject to capital gains tax. Capital gains refer to the increase in value of an investment and are taxable when a person or business sells its assets. The tax does not apply to investments you continue to hold. It is only paid if the investment is sold and you make a profit.
Essential things you need to know about taxes on crypto currency
Here are some important things you should know about how the IRS calculates taxes on cryptocurrencies:
1. Your annual income affects your tax rate
Just because cryptocurrencies are classified as real estate doesn’t mean you have to pay taxes on your investment every year like you do with traditional real estate. Tax is only charged if you decide to sell the stock and make a profit – just like with traditional stocks. These taxes are due regardless of the amount of crypto currency sold.
If you choose to hold your cryptocurrencies indefinitely, you won’t pay taxes no matter how much your assets increase in value.
However, how long you hold your cryptocurrency investments affects the amount of tax you have to pay. If you hold your cryptocurrencies for more than a year, you must pay long-term capital gains tax on accumulated profits.
Your annual income determines your long-term capital gains tax rate. If your income – assuming you are a single taxpayer – is less than $40,000 per year, you do not have to pay income tax. A 15% tax rate applies to annual incomes over $40,000 but less than $441,450; a 20% tax rate applies to incomes over $441,450.
Self-employed people like me find it easier to adjust their annual income, so use this rule of thumb.
Buy that expensive marketing seminar you heard positive feedback about at the end of the year, hire a web developer to improve your website, or buy new premises for your business. Any business expense that benefits you in the long run and reduces your total income for the year is valid.
If you have held your cryptocurrency investments for less than a year, you will be taxed at the standard income tax rate. In other words, you pay less tax if you hold investments in cryptocurrencies for longer than a year.
2. Losses may be deducted
The cryptocurrency markets have some similarities to traditional equity markets. Some traders become winners and some become losers. No matter how conscious you are about your cryptocurrency investments, some decisions you make will end up costing you money.
Fortunately, the IRS allows losses up to $3,000 to be used to reduce taxable income. Losses in excess of this amount may be carried forward to future years.
3. You still have to pay tax if you issue crypto currency
Paying for goods and services with cryptocurrencies is the same as selling them, according to the IRS. Many manufacturers, retailers and service providers now accept cryptocurrencies, but that won’t help you avoid taxes.
Any increase in value between the time you bought the cryptocurrency and the time you used it to pay for something is taxable.
For example, let’s say you bought bitcoins worth $2,000 in 2018 and used them to order a Tesla cyber truck when the value reached $58,000. The $56,000 of income from your investment is taxable. Taxes paid at the time of purchase of the vehicle do not cancel them out.
The only way to avoid paying taxes is if you earn less than $40,000 and hold cryptocurrencies for more than a year, as we discussed above.
4. All cryptocurrencies mined or received as payment are taxable
Miners of cryptocurrencies have an additional tax burden because the IRS considers these virtual currencies to be property. This means that all mining cryptocurrencies are immediately taxable. The same applies to all cryptocurrencies received as payment for goods and services or as part of a promotion.
Cryptocurrencies that fall into one of these categories are taxable based on their value on the date of receipt. They are taxed at the normal income tax rate.
Owning these cryptocurrencies does not exempt you from paying taxes. If the value of the cryptocurrency increases and you make a profit, you will have to pay capital gains tax on that profit. Similarly, losses can be used to reduce taxable income.
I don’t have much mining experience, but I plan to take advantage of these laws since I can write off all the equipment I bought.
Tax return for your investments in cryptocurrencies
The IRS recently stated that profits from cryptocurrencies are grossly undervalued, and it can be expected that sooner or later it will go after the lost revenue. To make tracking and paying taxes on your income easier, you can do the following simple things:
1. Recording of all transactions
The importance of keeping good records of the cryptocurrency purchases or sales you make each year cannot be overstated. Records must also be kept of cryptocurrencies received as payment or earned from mining. Also, keep an eye on any transfer and transaction fees, as these can be deducted from your total profit.
You don’t want to fall behind, as many cryptocurrency investors make thousands of transactions a year on multiple platforms.
There is no doubt that accounting for cryptocurrency investments presents unique challenges, so consider hiring a professional to manage your accounting if the volume of your transactions warrants it. Don’t worry, you’ll be able to deduct their commission from your taxable cryptocurrency income.
If you don’t trade enough cryptocurrencies to justify hiring a professional, try doing most of your trading on exchanges like Coinbase. These companies keep detailed records of all your transactions, making it easy to calculate profit or loss.
Accounting software can also help with record keeping, and some go so far as to scan the blockchain and find all the transactions associated with each portfolio during a given fiscal year.
Cointracker and Koinly are great apps to connect to wallets or exchanges and track transactions.
2. Using the correct tax forms
There are different tax forms for different types of cryptocurrency investors. These include:
- Form 8949: This form records all your purchases and sales of cryptocurrencies as an investor. It collects data on the number of coins you buy, records the value at the time of purchase and the value at the time of sale.
- Diagram D: This form is used to provide a summary of your total capital gains and losses for all your investments, including cryptocurrencies.
- Diagram C: This is the form you use when you have obtained the crypto currency by mining. The form must state whether you operate a mine as a business or as a hobby, which affects the tax rate. When mining cryptocurrencies as a business, taxes must be paid as a self-employed person.
- Diagram 1: This is the form you will find yourself in if you consider your cryptocurrency mining activities as a hobby. This limits the deductions you can claim, but you don’t have to worry about self-employment taxes.
3. Request for payment of taxes
Taxes on crypto-currencies are complicated enough on their own. You don’t want to complicate your life by worrying about back fees and other penalties for not filing your taxes on time or forgetting to report your cryptocurrency income.
Use the data you have kept throughout the year and ask an expert to help you with this if you have made a significant profit.
Minimize taxes on cryptocurrencies
Now that we’ve seen what your tax obligations are when it comes to cryptocurrencies, let’s see what you can do to lower your tax bill:
1. Use of long-term business strategies
If you hold cryptocurrencies for more than a year, you can take advantage of the long-term capital gains tax rate, which is lower than the short-term tax rate (calculated based on your income tax rate). People who earn less than $40,000 a year do not have to pay taxes on their holdings of crypto-currency.
The highest tax rate you pay on long-term capital gains is 20%, while the income tax rate can be as high as 37%.
In other words: Using trading strategies that allow you to hold your investments for at least a year can cut your tax bill in half.
2. Reduction in taxable income due to losses
As with any other investment, you should always add the losses incurred during the year if you have made a profit. For example, if you made $5,000 with bitcoin but lost $5,000 with dogecoin, you should not pay taxes because your net profit is zero.
You can also use losses from other investments to reduce your total taxable capital gains.
3. It’s time to sell cryptocurrencies with favorable income tax rates
Your annual income affects your long-term capital gains tax rate. You pay nothing if you earn less than $40,000 a year, 15% if you earn between $40,000 and $441,450, and anything above that is subject to a capital gains tax of 20%.
Keep this in mind if your income may increase or decrease significantly. The lower your income when you sell your assets and make a profit, the less tax you have to pay.
Are you planning to take time off from work and go back to school? You may want to wait until your income drops before selling the cryptocurrencies you own. Are you about to retire from a well-paying job? It is better to sell when your income is lower.
4. Recording of all decommissioning costs
Don’t let the naysayers fool you: Mining cryptocurrencies can be lucrative, especially if you are skilled enough to deduct all of your fees. Expenses for miners, internet access, electricity and any other expenses you incur while mining are deductible, even if you consider your mining activity a hobby.
5. Investing through a pension plan
That’s right, you can invest in cryptocurrencies through a retirement plan like Roth or a traditional IRA. This allows you to defer, and in some cases avoid, capital gains tax on your investments. To do this, you need to open a self-regulated IRA with a company that offers cryptocurrency investments.
You can also reduce your taxable income from cryptocurrencies by donating a portion of your cryptocurrencies to charities and causes you believe in. With your donations, you can take advantage of a deduction equal to the value of your assets, including any profits.
Expects to be challenged in the future
Cryptocurrencies only became mainstream a few years ago. Governments around the world are still trying to figure out how to regulate and tax these virtual coins.
Given the current tax laws on cryptocurrencies, long-term strategies that assume you will hold an investment for longer than a year offer the lowest tax rates. Short-term investments are always profitable because your income is taxed at the normal rate.
It is clear that the Wild West era of crypto-currencies is coming to an end. Now is the time to keep detailed records so you can determine how much tax you owe at the end of each year.
Frequently Asked Questions
How do taxes work with Crypto?
The IRS has not yet issued guidance on how to treat cryptocurrencies. The IRS has said that it will issue guidance in the future. What is the difference between a cryptocurrency and a token? A cryptocurrency is a digital asset designed to work as a medium of exchange that uses cryptography to secure its transactions, control the creation of additional units, and verify the transfer of assets. A token is an entity that has been issued by an organization with the purpose of raising funds for development or other purposes.
How much is crypto loss on taxes?
The IRS has not yet issued guidance on how to treat cryptocurrency transactions.
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