Cryptocurrency is a relatively new asset class that has created a vast amount of wealth for early investors. But whenever wealth is created, chances are it will end up getting taxed in some way.
Thankfully, the U.S. tax code includes some ways that crypto investors might be able to reduce the taxes owed on digital currency. Here are nine methods that might help you avoid taxes on cryptocurrency, depending on your situation.
How cryptocurrency taxes work
As a United States citizen, you owe taxes on the income you earn worldwide. Most people hold cryptocurrency as an investment. Under the current Internal Revenue Service virtual currency guidelines, cryptocurrency is most often treated as a capital asset. This means the tax you pay on it is capital gains tax. (Cryptocurrency may also be received as income, which we share more about in a bit.)
You pay capital gains taxes depending on the type of capital gain you have. The two types are short-term and long-term capital gains and are based on how long you hold the asset, in this case, the cryptocurrency.
- Short-term capital gains occur when you sell cryptocurrency for more than you bought it and held the investment for a year or less. These are taxed at the taxpayer’s ordinary income tax rate, just like wage income.
- Long-term capital gains are realized when you sell cryptocurrency for more than you bought it but held the investment for longer than a year. These gains are taxed at more favorable long-term capital gains tax rates, which can be as low as 0%.
It’s essential to realize that virtual currencies are relatively new, and the IRS or Congress may change their stances on crypto taxes in the future. But based on the current taxation of cryptocurrency, here are a few ways you might be able to help reduce or eliminate the potential taxes you may owe.
Buy crypto in an IRA
You may be able to invest in cryptocurrency in a tax-advantaged manner by purchasing it in a self-directed IRA. Most IRAs allow you to invest in standard investments, including stocks, mutual funds, or exchange-traded funds (ETFs). Self-directed IRAs are special IRAs that allow you to invest in unique assets, such as cryptocurrency, precious metals, and real estate.
First, you must find a self-directed IRA that allows you to invest in the cryptocurrency of your choice. Be sure you understand how to buy cryptocurrency in the self-directed IRA you choose before moving forward. Once you have an account set up, your tax benefits will vary depending on your tax situation and the type of IRA you open and contribute to.
Traditional IRAs may allow you to make tax-deductible contributions, but you will have to pay ordinary income taxes on withdrawals in retirement. Roth IRAs require you to contribute post-tax money to the account but allow you to withdraw funds in retirement tax-free as long as you meet the requirements. For more information, check out our guide on Roth vs. traditional IRAs.
Move to Puerto Rico
If you have substantial cryptocurrency wealth, moving to Puerto Rico might help you avoid some U.S. federal income tax. Puerto Rico is a U.S. territory with unique tax benefits, including a 100% exemption on capital gains. For this reason, moving to Puerto Rico could save you a significant sum on your tax bill, whether you’re looking to save on crypto or even to avoid capital gains on stocks.
This strategy isn’t as beneficial as it may seem, though. You have to become a bona fide resident of Puerto Rico and maintain that residency to qualify to file your taxes there. Additionally, any gains on your cryptocurrency before moving and establishing bona fide residency in Puerto Rico are still taxable in the United States at the applicable tax rates. This strategy is extremely complex, so you should consult a tax advisor before considering it.
Declare your crypto as income
If you receive cryptocurrency in exchange for goods and services or mine cryptocurrency, taxation works differently. In these cases, your cryptocurrency is treated as income when you receive it. You must record and report the fair market value of the cryptocurrency you received and count it as income on your tax return.
When you report this income, it’s taxed at ordinary income tax rates. These are higher than capital gains tax rates. Your basis, a tax term used to define the currency’s initial value when you received it, for the cryptocurrency you receive is the amount you report as income. When you eventually dispose of the cryptocurrency, you use that basis to calculate any capital gain you may have and pay the applicable capital gains taxes.
This is also the case for mining cryptocurrency. However, mining cryptocurrency is usually considered a self-employment activity. This means you’ll need to pay self-employment taxes in addition to ordinary income taxes.
Hold onto your crypto for the long term
As long as you are holding cryptocurrency as an investment and it isn’t earning any income, you generally don’t owe taxes on cryptocurrency until you sell. You can avoid taxes altogether by not selling any in a given tax year.
You may eventually want to sell your cryptocurrency, though. To lower your tax burden, make sure the cryptocurrency you sell has been held for more than a year. If it has, your cryptocurrency sale may qualify for the lower long-term capital gains tax rates. This could save you a significant amount of money on your tax bill.
Offset crypto gains with losses
When you sell an investment, you realize a gain or a loss. Which you realize depends on how much you sold the asset for and its cost basis. The good news about the U.S. tax code is that capital gains and losses can offset each other. If you consciously use this to your advantage, this is called tax-loss harvesting.
Technically, gains and losses of the same type offset each other first. Short-term gains would offset short-term losses and the same for long-term tax items. Then, you can offset any resulting net loss against a net gain of the other type.
Let’s say you have a $1,000 short-term loss, a $2,000 short-term gain, a $3,000 long-term gain, and a $5,000 long-term loss. In this case, you’d end up with a $1,000 net short-term gain and a $2,000 net long-term loss. Then, you’d net these values against each other to end up with a net $1,000 long-term loss.
If you have an overall capital loss for a year, you can claim up to $3,000 of it. Any leftover loss can be carried forward to future years. Many of the best robo-advisors offer automatic tax loss harvesting for investors.
Sell assets during a low-income year
Whether you have short-term or long-term capital gains, your income determines the tax rate you pay. The lower your taxable income is, the lower your tax rate will be. You might save money on taxes by selling cryptocurrency that you know will experience gains in years in which you know you’ll pay taxes at a lower tax rate.
Selling cryptocurrency might result in some of the income being taxed at a higher rate, but that does not push all of your income into a higher tax bracket as many people believe.
Donate to charity
Donations to a qualified charity may be tax-deductible if you itemize your deductions. To qualify, you must have held the asset for at least one year before donating it.
Donating property, such as cryptocurrency, might result in favorable tax treatment. You typically get to deduct the fair market value of your cryptocurrency, but you don’t have to pay capital gains taxes when doing so.
There are limitations to the deduction amount, so check with your tax professional to see how a donation could help your tax situation.
Give gifts to your family
Gifting cryptocurrency may help you avoid taxation on your gains. The recipient won’t have to pay a gift tax, either. Under current rules, you can give up to $15,000 per person per year without filing a gift tax return or paying any gift taxes. Even if you exceed the $15,000 limit, you still won’t have to pay gift taxes unless you’ve used up your entire $11.7 million lifetime estate exemption.
The recipient of the cryptocurrency will need to know your basis in the cryptocurrency to determine the tax they owe when they eventually sell it. They will have to pay tax on the entire gain above your basis, but that tax may be less than if you paid it yourself.
For instance, an adult in their fifties with a profitable career is likely in a higher tax bracket than a recent college graduate working their first job. So if you gift your crypto to a younger family member, the overall tax liability on that currency might end up being less.
Hold onto it until you die
If you don’t need to access the money you’ve invested in your cryptocurrency, you might want to use it as a generational wealth-building tool. You must believe in the long-term value of a cryptocurrency for this to work, but this strategy might offer outstanding tax treatment.
When you die, your assets receive what’s called a step-up basis when they are passed on to your heirs. Let’s say you bought $1,000 of bitcoin today that is worth $250,000 when you die in 20 years. If you sold the bitcoin right before you died, you’d have to pay taxes on a $249,000 gain.
If you die and pass the bitcoin on to your heirs, the basis gets increased from $1,000 to the $250,000 it is worth at the time of your death. Then, your heirs can sell it immediately without paying any income tax on the asset since their basis is equal to their selling price.
To make sure you arrange this sort of inheritance properly, make sure you talk to a financial professional who specializes in estate planning.
Do I have to pay taxes on my crypto?
As a United States citizen, you do have to pay taxes on your cryptocurrency. Individuals usually hold cryptocurrency as an investment, so it is subject to capital gains tax rules in the United States. Cryptocurrency held for a year or less is subject to short-term gains rates. Cryptocurrency held for more than a year is subject to more favorable long-term capital gains rates.
Will my crypto exchange send me a 1099?
Your cryptocurrency exchange may send you a 1099 tax form reporting certain income-based activity. In some cases, this could be rewards or the total volume of your cryptocurrency sales over the year. Unfortunately, this form doesn’t provide all the information you need to fill out your tax return. You need to know when you bought cryptocurrency, how much you paid for it, how long you held it, when you sold it, and how much you sold it for to calculate your capital gains taxes owed correctly.
Which country has no tax on cryptocurrency?
Many countries offer no taxes on cryptocurrency transactions, depending on your specific circumstances. Some of these countries include Germany, Singapore, Portugal, Belarus, and Switzerland. They may tax business cryptocurrency income or tax cryptocurrency in some other fashion, so it’s important to discuss this with a tax advisor. Tax laws also change constantly, so you need to stay up to date on any changes.
And while several countries have no tax on cryptocurrency, this does not help U.S. citizens. U.S. citizens are taxed on their worldwide income, including cryptocurrency gains. You would have to renounce your U.S. citizenship to avoid this worldwide income tax.
Investing money in crypto assets might result in significant gains if you purchased the assets before they drastically increased in value. If you’re lucky enough to experience this, then a little bit of tax planning might help you reduce the taxes you owe on your crypto gains. The list of ideas above could help you when speaking with a tax professional.
Keep in mind, cryptocurrency taxation is extraordinarily complex, and the tax implications might change in the future. For this reason, it’s always best to consult a tax professional such as a Certified Public Accountant (CPA). They can help you make sure you’re following the applicable tax rules while helping you minimize any tax you may owe.