Understanding Cryptocurrency Capital Gains Tax
After a brief rise in 2017, bitcoin surged again in late 2020, closing the year with a single coin worth just under $30,000.
Many investors were enticed to invest in bitcoin for the first time, while others who had been hanging onto their bitcoin for some time taking advantage of the token’s skyrocketing price to profit from part of their holdings.
However, with Tax Day approaching, some users will discover that they now owe taxes on those earnings. You may be liable to pay depending on when you acquired and sold your bitcoin, as well as other criteria such as your income.
If you’re wondering if is cryptocurrency taxed, here’s all you need to know about declaring cryptocurrency gains on your taxes. However, before we delve into the details, let’s first get a better understanding of what cryptocurrency is.
What Is Cryptocurrency
Digital ‘cryptocurrency’ or ‘crypto assets,’ such as stable coins and tokens, are a type of decentralized digital money based on blockchain technology — a distributed ledger enforced by a diverse network of computers. From decentralized digital tokens like Bitcoin to official, sovereign-backed, central bank digital currencies – digital money is gaining acceptance and popularity among its users.
These digital currencies seek to replicate traditional money’s functions as a method of payment, a store of value, and a unit of account. They are mostly used for investment, but companies have also utilized them as payment in place of products and services provided. Because they are not issued by any central body, these cryptocurrencies are currently immune to government interference and exploitation.
There were over 4,000 different cryptocurrencies in circulation worldwide as of early 2021, including market giants Bitcoin, Ethereum, Litecoin, and Dogecoin. Despite the exponential growth in the number of digital currencies, the top 20 cryptocurrencies control 90% of the market. As of May 2021, the total value of all cryptocurrencies in the world was $2.8 trillion.
What Is The Cryptocurrency Tax Rate?
When it comes to federal income tax considerations, cryptocurrency is considered “property.” The IRS regards it as a capital asset for the average investor. As a result, crypto taxes are the same as taxes on any other capital gain generated on the sale or exchange of a capital asset.
When you buy a capital item, whether it’s a stock, bond, home, widget, Dogecoin, Bitcoin, or other investment, you set a basis equal to the cost of acquisition. When you sell anything, you compare the sales proceeds against the basis to see if you made a profit or a loss. You have a capital gain if your proceeds surpass your base. You incur a capital loss if the situation is reversed.
You should also examine the length of time you kept the asset. Your earnings or losses will be classified as “short-term” or “long-term” depending on how long you keep your cryptocurrency. This distinction will also have a significant impact on the amount of tax on the cryptocurrency you must pay, as highlighted below:
- Short-Term Capital Gains and Losses: A short-term capital gain or loss occurs when you acquire and sell an asset within a 365-day period. Short-term profits are taxed at the same rates as regular income, which includes wages, salaries, commissions, and other forms of earned income. As of 2021, the IRS has seven tax rates for regular income, ranging from 10% to 37%.
- Long-Term Capital Gains and Losses: The difference between the sales price and your basis is a long-term capital gain or loss if you acquire an asset and sell it after a year. Because the rates are normally lower, you’ll pay less tax on a long-term gain than on a short-term gain. Long-term capital gains are now subject to three different tax rates: 0%, 15%, and 20%. The amount you pay is determined by your income.
When Does Crypto Tax Apply To Your Coins?
So, when is bitcoin taxable? The cryptocurrency tax rates as of 2021 apply to the following short-term capital gain and long-term capital gain tax events:
Selling Your Coins For Fiat Currency
This event occurs when you sell your crypto coins in exchange for fiat currency, including the pound sterling, the euro, and the US dollar. For example, suppose you pay $1,000 for two ETH (Ethereum) and then sell them for $700 a few months later. The $300 capital loss will be deducted from your taxable income.
Using Your Coins To Purchase Something
For example, prior to 2014, you purchased 5 bitcoins for $150 each in a bitcoin transaction. Now, with your newfound fortune, you buy a brand new motorcycle for $56,000 using 1 bitcoin, which was worth $56,000 at the time of purchase.
In this case, you have a taxable event when you sell your bitcoin for a motorcycle (i.e., you make a bitcoin transaction). As a consequence, you have a $55,850 capital gain ($56,000 – 150) that you must declare on your taxes.
Trading One Crypto Asset For Another
This can be done directly between peers or through an exchange. Consider the following scenario: you paid $500 for 10 Litecoin. You exchanged all of your Litecoin for 1 ETH after a few months (Ethereum). 10 Litecoins were valued $3,000 when you made the deal.
Trading your Litecoin for Ethereum resulted in a capital gain of $2,500 ($3,000 – $500), which you must disclose on your taxes. It’s crucial to remember that just moving an asset from one exchange or wallet to another is not a taxable transaction because no capital gains or losses are generated.
Tips To Follow To Reduce Your Crypto Tax
If you’re wondering how to reduce your cryptocurrency tax, follow the steps given below:
Convert Your Short Term Gains Into Long Term
As previously stated, depending on how long you possess your cryptocurrency, different capital gains rates will apply. Hold your cryptocurrencies long enough to transform short-term profits into long-term gains if you want to reduce your tax burden. It won’t be easy, but if you have the patience and courage to hold on to your cryptocurrency for at least a year before selling, you’ll likely pay a lower tax rate on any capital gains.
Offset Capital Gains with Capital Losses
Another way to reduce the amount of money crypto investors have to pay in taxes is to balance capital gains with capital losses. This works by deducting taxable gains on cryptocurrencies or other investments that have increased in value from losses on crypto-assets sold throughout the year.
However, you should be aware that this technique has limitations. You must first offset losses of the same type when you recognize investment losses. Short-term losses, for example, diminish your short-term bitcoin profits initially, whereas long-term losses reduce your long-term gains.
Consider Selling Your Coins In A Low-Income Year
When you’re waiting for your crypto profits to transition from short to long-term, another factor to consider is selling during a low-income year.
Short-term and long-term returns can both be reduced by selling during a low-income year. You won’t have as much extra income tacked on to drive you into a higher tax rate if you have short-term profits that are taxed as regular income.
If you sell short-term assets when you retire and stop working, your tax rate might be fully determined by the income from your short-term profits. A lower total income for the year might also entail a reduced tax rate on long-term capital gains.
This is because the long-term capital gains rate that applies to you – 0%, 15%, or 20% – is calculated using your taxable income. As a result, if you have less taxable income, your longer-term capital gains tax rate is more likely to be lower.
You may also have little to no income during the year if you want to retire early and have saved enough money to cover your living expenses until you can take monies from your retirement accounts. If that’s the case, now is a great opportunity to lock in long-term capital gains and potentially save money on taxes.
Focus On Reducing Your Taxable Income
Another tried-and-true tax reduction approach is to reduce your taxable income. This is similar to selling valued investments in a low-income year. This entails searching the tax law for tax credits and deductions that might reduce your taxable income.
You can, for example, pay for expensive medical treatments, contribute to a standard IRA or 401(k) plan, fund a health savings account, or make a cash or property donation to charity. You may also be eligible for a variety of additional tax breaks and credits. You might also want to see a tax professional to learn more about any additional tax benefits you can take advantage of.
Invest In A Self-Directed Individual Retirement Account
Investing in a tax-deferred or tax-free Self-Directed Individual Retirement Account (SDIRA) is another way to reduce your crypto tax liability. As a result, you can either pay taxes later when you may have a lower taxable income in retirement, or pay taxes up front, when you contribute to your Roth SDIRA if you expect to pay greater taxes in retirement.
Gift A Family Member
Another method to reduce your crypto tax burden, depending on your intentions for spending your money, is to give your bitcoin to family members.
The IRS enables you to make tax-free gifts of up to $15,000 per person each year. While the cryptocurrency’s basis passes to the new owner, the receiver may have a low enough income to avoid paying taxes on the appreciated property when it is sold. At the very least, you’ll pay less in taxes than you would if you sold the cryptocurrency instead.
In conclusion, do you have to pay taxes on bitcoin? Yes, but it depends. As you can see, there are a number of elements to consider when calculating your cryptocurrency tax rate. Other credits, exemptions, and deductions that might decrease your overall taxable income could change the actual tax rate on cryptocurrency profits.
In the meantime, if you’re worried about taxation fraud or have any concerns related to cryptocurrency taxation, you should consider contacting us at CharterCPA, wherein our team of experts will be able to assist you effectively. So, schedule a call with us today!