Cryptocurrency has been a hot topic in 2021 so far, and many investors have seen their portfolio value skyrocket this year as a result. What investors might not consider is the taxes they are required to pay, but also the possible legal ways to pay less tax. This article will explain everything you need to know about how to legally reduce your tax burden on cryptocurrency gains – or how to avoid paying taxes completely.
How cryptocurrency is taxed in the US
In our in-depth guide Cryptocurrency & Bitcoin Taxes: Complete Tax Guide 2022, we have explained all the tax rules surrounding bitcoin and cryptocurrency in the US in great detail. The short summary is that if you are reporting and paying taxes in the US, you will need to report your capital gains transactions on Form 8949 and Schedule D every year.
Cryptocurrency is considered property for taxation purposes in most countries today, including the US. This means that if the price of a cryptocurrency you have bought appreciates in value before you sell it, you will need to pay capital gains tax. You must calculate the initial purchase cost and proceeds value for every transaction before working out the gain/loss for all taxable events during the tax year. Generally speaking, all transactions where any coins or tokens are disposed of are considered taxable events. This includes also every crypto-to-crypto trade, if you have swapped tokens on a DEX like Uniswap, or if you have traded futures on a derivatives exchange.
To complicate things even more, there are special tax rules for mining, staking, airdrops, DeFi, and NFTs. It is therefore very easy to get lost when it comes to crypto tax reporting, which is why most investors and traders prefer to use a cryptocurrency tax tool to help them generate all the required tax forms and reports.
Let’s now dive into how you can actually reduce or avoid paying taxes on your cryptocurrency gains – legally!
Long-term capital gains
The crypto market can be very volatile, and you might experience the coins in your portfolio increasing significantly in value in a short time. Many investors are therefore often tempted to sell the coins and perhaps invest in another coin or crypto project instead. What is important to be aware of is that the capital gains tax rate is lower for coins held for one year or longer before selling. Gains on assets sold within one year are taxed as ordinary income, while assets held longer are taxed as long-term capital gains. This means that you can potentially reduce your tax burden significantly by holding onto your investments for a minimum of one year – if you got the patience.
The long-term capital gains tax rate in the US is either 0%, 15%, or 20% depending on your total ordinary income. If your taxable income is less than $80,000, your long-term gains are in fact not taxed at all. This is great news for any crypto investor that has held their coins for a year or longer.
Offset gains with losses
A capital gain or loss is realized every time you sell or otherwise dispose of a crypto asset. This is how you calculate your capital gains:
capital gains = selling price – purchase price
The selling price is the fair market value of the cryptocurrency sold at the time of the transaction. The purchase price, often referred to as cost basis, is usually calculated using either FIFO or LIFO cost basis method. Luckily for US taxpayers, your capital gains and losses will offset each other, so you will only pay taxes for your total net gains during the tax year. Many crypto investors and traders are using a technique called tax-loss harvesting to maximize the capital losses that can be used to offset the total gains. This is 100% legal in the US since the IRS has not issued any guidance that prohibits doing this for cryptocurrencies.
Not only are you allowed to offset your gains with losses, but you can also offset your ordinary income with up to $3,000 each year in the case where your total losses exceed your total gains. Luckily, any losses exceeding this value are not lost forever, but can instead be carried over to future years and used to offset your gains in those years. The most important takeaway from this is that if you have made a total capital loss during any tax year, you can potentially reduce your tax burden in the future significantly by reporting the loss in your tax return. This is something that may become very relevant if we enter another crypto bear market similar to 2018 sometime in the future.
A Self-Directed Individual Retirement Account, or Self-Directed IRA account for short, are special retirement accounts that allow you to invest in unique assets such as cryptocurrencies. By having a Self-Directed IRA account, you might be able to get direct exposure to the crypto market while at the same time getting all the tax benefits that come with this type of account. One of the tax benefits of an IRA account is that you may pay taxes later in the future when you have a lower taxable income amount, thus lowering your total tax burden.
The tax rules vary for the different types of IRA accounts, so if you are considering setting this up, you should consider contacting a tax professional that can guide you in the process so that you find the optimal tax strategy that suits your needs best.
Donate to charity
Did you know that in the US, you can donate cryptocurrency to a charitable organization without paying capital gains tax? Not only can donations be considered tax-free, but you might also be allowed to claim a significant tax deduction based on the value of the donation at the time of donating!
The general rule is that you can deduct the total fair market value of the cryptocurrency at the time when you made the donation, but there are certain limitations to the total allowable amount.
There are also some requirements that must be met for the donation to be exempt from the capital gains tax, so be sure that you are aware of the latest guidance from the IRS about this topic. It is recommended to consult a tax professional if you are planning on donating cryptocurrency to charity to make sure you qualify and get all the tax benefits you want.
Move to Puerto Rico
How does living in a tropical paradise, surrounded by palm trees and white beaches, and on top of that paying zero tax on your crypto gains? Well, this is actually the reality for quite many crypto investors today that made the move to Puerto Rico! The island is a US territory with unique tax benefits and is perhaps most famous for having zero capital gains tax. Yes, you read that right. Zero capital gains tax.
It’s, therefore, no wonder that Puerto Rico has become one of the hottest “crypto hubs” in the last couple of years, attracting many young and wealthy investors and traders from all over the country. There are, of course, certain requirements you must fulfill to be eligible for the tax advantages Puerto Rico offers.
Maybe the most important factor to consider is that any unrealized gains on crypto assets before moving to Puerto Rico are still taxable in the US at the applicable tax rates. The regulation and process of moving from the US to Puerto Rico are fairly complex, so you should always consult a tax professional before making this decision.
Leave the US
If your goal is to avoid taxes on your cryptocurrency completely, the best option might be to leave the US entirely. As a US citizen, you are still taxed in the US even though you are a resident of another country where you also pay taxes. That means you cannot simply book a flight ticket and apply for residence in a different country if you wish to avoid paying US taxes. You actually have to give up your US citizenship!
Leaving the US for a more tax-friendly country is something that many crypto investors might be considering. Giving up your citizenship will require a lot of planning before you can actually do this, so the best advice would be to do a lot of research before starting this process. There are also several consultants that specialize in helping Americans move to a different country and give up their citizenship, and to find the tax strategy that suits them best.
If you are considering this, one of the first things you need to consider is where you will actually move. There are several countries that can provide a lot of tax benefits for crypto investors, and in fact, some countries don’t even tax crypto gains which means you might be able to avoid paying taxes on your gains completely.
HODL your coins
The last strategy for avoiding taxes on your crypto gains we will present in this article might actually be the best strategy for most investors – to become a HODLer. The word HODL actually refers to a misspelling of “hold” from 2013 and has now become a well-known expression in the crypto community. If you are a HODLer, it literally means that you are planning on never selling your coins, and thus never triggering any capital gains tax.
There are also other great benefits to being a HODLer, such as less stress that is often associated with active trading, but also the fact that you can safely “forget” about your investment for a very long time until you eventually plan on selling, spending, or gifting your coins in the future.
If you plan on never selling your cryptocurrency before the day you die, the person that inherits your assets will actually be able to sell your coins without triggering any capital gains tax at all. In this case, the cost basis gets increased to the fair market value at the time of your death. This might be something to consider especially if you have children or grandchildren you want to transfer your crypto wealth to in the future.