Cryptocurrency has been and is still among the hottest topics in financial news. According to statistics, 2021 was a big year for cryptocurrency, with more than half of investors investing for the first time. More than 10% of Americans have been reported to invest in cryptocurrency in the last year. So, being one of them, how do I pay taxes on crypto?
Though cryptos were designed to be decentralized and free of government scrutiny, you may owe taxes if the value of your coins has grown. We know it is not the most exciting part of the crypto investment, but you need to understand how to pay your crypto taxes, whether using the cryptos as an investment or like you would cash.
What are Cryptocurrency Taxes?
For federal income tax purposes, cryptocurrency is usually considered “property.” On the other hand, for the normal investor, the Internal Revenue Service (IRS) considers it a capital asset. Consequently, crypto taxes are the same as any other taxes you pay after the gain earned on the sale or exchange of a capital asset.
How is Crypto Taxed?
As mentioned, the IRS usually treats cryptocurrencies as property and investment rather than virtual currency. So, all transactions, from selling crypto to using it to make purchases, are taxed similarly to other capital gains and losses.
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As a result, long-term cryptocurrency investors have a significant opportunity. If you hold onto your crypto for at least a year, you can enjoy lower long-term capital gains taxes, which vary from 0% to 20% based on your income level. On the other hand, short-term cryptocurrency gains on purchases held for a year or less are taxed at the normal income rate: Depending on your federal income tax bracket, the rate will range from 10% to 37%.
These taxes usually apply even when you use cryptocurrency to make purchases, meaning you might be liable for sales tax as well as taxes on any crypto gains since you initially bought or received it. You also owe taxes on crypto if you earn it through mining or get it in exchange for products and services.
Ultimately, you owe taxes on crypto depending on the value of the cryptocurrency on the day you receive it, taxed at your ordinary income tax rates. Also, keep in mind that you may also owe taxes if you subsequently sell the cryptocurrency you mined or received for a profit.
What Are the Main Types of Crypto Tax Events?
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Consider how you used your cryptocurrency the previous year to determine if you owe crypto taxes. Transactions that result in a tax are referred to as taxable events. Those that do not are referred to as non-taxable events. Let’s discuss the types of cryptocurrency tax events.
1. Taxable Events
i). Taxable as capital gains
- Converting one cryptocurrency to another
- Selling cryptocurrency for cash
- Spending cryptocurrency on goods or services
ii). Taxable as income
- Mining cryptocurrency
- Getting paid in cryptocurrency
- Getting cryptocurrencies in exchange for goods or services
- Getting crypto from a hard fork
- Earning other income
- Getting cryptocurrencies from an airdrop
- Getting other incentives or rewards
2. Non-Taxable Events
- Buying cryptocurrency in cash and holding it
- Giving/receiving cryptocurrency as a gift
- Donating cryptocurrency to a non-profit or a qualified tax-exempt charity
- Transferring cryptocurrency to yourself
Tips on How to Minimize Your Crypto Taxes
1. Sell Your Crypto in a Low-Income Year
As you wait for your cryptocurrency profits to convert from short- to long-term, consider another timing factor: selling in a low-income year. Selling during a low-income year can save you money on taxes on both short-term and long-term profits.
That means if you have short-term profits, usually taxed as regular income, you won’t have as much more income to push you into a higher tax bracket. On the other hand, the long-term capital profits rate that applies to you, either 0%, 15%, or 20%, is determined by your taxable income. As a result, your longer-term capital gains tax rate will likely be lower if you have less taxable income.
2. Hold Your Short-Term Gains Until They Turn Into Long-Term Gains
As mentioned earlier, different capital gains rates will apply based on how long you hold your cryptocurrencies. We recommend holding your cryptos long enough to convert short-term gains into long-term gains, and as a result, your tax burden will be lower.
3. Lower Your Taxable Income
Another tried-and-true tax minimization approach is reducing your taxable income, which is closely tied to selling your valued investments in a low-income year. This means scouring the tax law for tax breaks and credits that might reduce your taxable income.
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For instance, you can contribute to a traditional IRA, put money in a health savings account, take care of expensive medical procedures, or donate cash or property to charity.
4. Gift the Crypto Assets to Your Family Members
Depending on your spending plans, consider gifting your crypto to family members to reduce your crypto tax burden. Fortunately, the IRS allows you to make tax-free gifts of up to $16,000 per person within a year.
5. Offset Your Capital Gains with Capital Losses
Another way to minimize crypto taxes is to balance capital gains with capital losses. This works by deducting losses on cryptocurrency assets you sold throughout the year from taxable gains on cryptos or other investments that have increased in value.
6. Move to a State With Low or No Income Tax
Luckily, a few tax-friendly states offer low or no income taxes. That means you will only pay federal taxes. So consider relocating to a low or no-income-tax state to minimize or even eliminate taxes on your crypto income.
7. Donate Your Appreciated Crypto to Charity
You can donate your crypto to charity as you would gift appreciated cryptocurrency to a family member. This will result in no capital gains tax and a substantial tax reduction you can claim on your tax return.
8. Bequeath Your Crypto Assets in Your Will
The last crypto tax reduction tip is to include your crypto assets in your will. This way, your heirs can sell the crypto they inherited without tax consequences based on its fair market value.
How to Report Crypto on Taxes
When you purchase and sell cryptos, you need to record any gains (or losses) to the IRS. To be accurate, when you report the taxes, you need to be more organized throughout the year than someone who does not have investments. But the best thing is that most cryptocurrency exchanges offer transaction reports that detail every purchase, sale, and exchange activity in your account.
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Getting the information required to report crypto on your tax return should be easy if you do all cryptocurrency transactions on a single exchange. However, suppose you have cryptocurrency transactions across multiple exchanges, such as crypto wallets or crypto credit cards. In that case, things may become more complicated because you must obtain a report from each place where a transaction happened or track the transactions yourself.
Once you have collected all your transactions, you need to record all cryptocurrency transactions on IRS Form 8949 and Sales and Other Dispositions of Capital Assets. The IRS form is divided into two parts: short-term (for cryptocurrency kept for less than a year) and long-term (for cryptocurrency held longer than one year).
Assume you previously purchased one Bitcoin for $20,000. The following are some instances of taxable events:
- If you sold one Bitcoin for $50,000, you would report $30,000 in gains.
- If you sold one Bitcoin to buy a $45,000 car, you would report $25,000 in gains.
- If you trade one Bitcoin for $60,000 of another crypto, you would report $40,000 in gains.
Frequently Asked Questions on How Do I Pay Taxes on Crypto
1. How Much Crypto Tax Do I Owe?
The tax you owe on your cryptocurrency is determined by your income level, tax bracket, how much you spend or trade, and how long you hold the cryptocurrency. For instance, if you have held it for less than a year, you will owe taxes at your ordinary income tax rate, and if you have held it for more than a year, you will incur capital gains taxes.
2. How Can I Avoid Paying Crypto Taxes?
Unfortunately, there are no legal ways to avoid paying your crypto taxes other than not using it. So if your cryptocurrency appreciates, you’ll have to pay taxes when you use it, convert it to fiat, sell it, exchange it, or trade it.
3. Can I Write off Crypto Losses?
Yes, if you have losses on Bitcoin or any other crypto, ensure to report them on your tax return and consequently reduce your tax liability through a process known as tax-loss harvesting. The process for reducing capital losses on crypto or other digital assets is the same as for losses on stock or bond sales. However, the highest amount you can write off in a single year is $3,000.
4. Do I Have to Pay Crypto Taxes If I Don’t Sell It?
You only pay taxes on your cryptocurrency when you make a profit, which happens when you sell, trade, or use it. As mentioned earlier, holding crypto is not a taxable event.
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