Introduction

U.S. taxpayers have an obligation to both report their cryptocurrency transactions to the IRS and pay taxes on it. Individuals who hold on to their cryptocurrencies as an investment are subject to short- and long-term capital gains tax rates when they sell or dispose the crypto. Taxpayers who are fortunate enough to have a lower basis in their crypto compared to the fair market value upon the crypto´s sale or disposition will have a capital gain, which is taxable. This article, written by the Blockchain and Cryptocurrency attorneys at Oberheiden, P.C., provides an overview of cryptocurrencies and the IRS and a list of tips for deferring or reducing your crypto tax liability.

Cryptocurrencies and the IRS

The IRS has long concluded in its Notice 2014-21 that cryptocurrencies should be treated as property—an asset—for federal income tax purposes, and not currency. In 2019, in addition to sending out multiple warning letters to taxpayers who allegedly failed to report cryptocurrency-related income, the IRS added a new question on Form 1040: “At any time during [the taxable year], did you receive, sell, send, exchange or otherwise acquire any financial interest in any virtual currency?” Therefore, every Bitcoin and other cryptocurrency transaction must be reported on an individual´s tax return. Failure to do so could lead to fines and penalties and even criminal prosecution.

Reporting your cryptocurrency transactions could result in a hefty tax bill. The next section outlines ten tips for deferring or reducing your tax liability.

Ten Tips to Defer Your Crypto Income

Below are tips of how you can defer your crypto income and, therefore, lessen your tax liability this tax year:

1. Hold your short-term crypto investments until they become long-term: Taxpayers are subject to different tax rates depending on whether they hold short- or long-term investments. This includes crypto investments. If you want to lower your tax liability, hold your crypto investments so that they qualify for long-term capital gains treatment. Buying and selling crypto within one year will cause you to recognize a short-term capital gain or loss. These tax rates are the same that you pay on ordinary income, which could range from 10% to up to 37%. However, if you hold your crypto investments for over one year before you sell, you will have a long-term capital gain or loss. Long term capital rates are preferential, either at 0%, 15%, or 20% depending on your income. Therefore, you will pay less tax.
2. Offset your capital gains on your assets with your capital losses: This strategy allows taxpayers to subtract their losses on crypto assets for the year from their gains. So if you sell crypto and have a loss, you can offset that loss against the gains you made by selling other cryptos for the year. After you offset your capital gains and you still have a net capital loss available, you can use up to $3,000 of this capital loss to reduce your ordinary income.
3. Sell or dispose your crypto investments during a year that you made less money: As discussed, long term sales or dispositions are taxed at preferential rates. But if you sell short-term crypto investments during a year in which you made less income, your tax rate will be lower because short-term capital rates are the same as ordinary income rates—based on your total taxable income. If you had less income for the taxable year, you would likely have a lower tax rate on both short- and long-term capital rates. This reduces your overall tax liability.
4. Purchase cryptocurrencies in an IRA: The reason why investing cryptos in a self-directed IRA is a tax strategy to defer taxes/reduce tax liability is because these IRAs require taxpayers to pay taxes either later when the taxpayer has lower taxable income or upfront upon contribution where you expect higher tax liabilities later. Special IRAs such as Roth IRAs generally allow you to withdraw funds tax free under certain circumstances.
5. Give your crypto assets to a family member as a gift: If you give your family members the gift of crypto during the tax year, the IRS allows taxpayers to exclude up to $15,000 per year per person without tax liability. This $15,000 exclusion amount applies for tax year 2021 and is $16,000 for tax year 2022.
6. Donate your crypto assets to charity: If you donate your appreciated crypto assets to charity, you can definitely reduce your tax burden. Charity donations of crypto assets lead to no capital gains tax as well as a deduction for the charity donation on your tax return.
7. Move to a state that does not have a state income tax: Some states have no income taxes, meaning that you can completely eliminate state taxes on all income from all sources. Also, in addition to states that have no income taxes, there are also crypto-friendly states that offer low state income tax. In these cases, you will have to pay only federal taxes or federal taxes and a small amount of state taxes.
8. Invest in an opportunity zone funds: This option allows taxpayers to defer and reduce their crypto gains by investing in an opportunity zone fund. To do this, the taxpayer places the proceeds of the sale of stock or other asset—such as cryptos—into a fund that is designed to increase investment in a disadvantaged zone. Taxpayers have about six months to move the money and can generally defer capital gains tax until 2026.
9. Find other ways to reduce your taxable income such as deductions: The tax code is filled with business deductions, credits, strategies, and other ways to reduce your taxable income even further. This includes deductions for donations or charity contributions, medical bills, contributions to a 401(k) plan or IRA, and so on.
10. Hire an experienced crypto tax attorney or CPA to evaluate your crypto tax liability: A tax attorney or CPA can help you evaluate your options and eligibility for various deductions for trade or business expenses, credits, and other tax strategies to defer taxes on your crypto investments and reduce your tax liability.

“Individuals seeking to defer or reduce their cryptocurrency profits and tax liability need to plan ahead. Such planning requires retaining an experienced crypto tax attorney or CPA to research how, when, and to what extent your tax liability could be deferred, reduced, and sometimes eliminated.” – Dr. Nick Oberheiden, Founding Attorney of Oberheiden P.C.

Conclusion

Cryptocurrency income and investments can produce ordinary or capital income. The tax rate applicable to the specific transaction depends on the nature of the transaction and the holding period. Taxpayers are obligated to report their cryptocurrency income on their tax returns. This is now a formal requirement—one that can be criminally prosecuted if failed to do so or if done falsely. Therefore, many taxpayers are turning to tax professionals such as crypto tax attorneys and CPAs to advise them on how to defer their crypto investments and reduce their tax liability.