3 ways savvy crypto investors are using the tax code to their advantage
It’s officially tax season, and if you were among the many cryptocurrency traders last year, it’s time to report your business on your 2021 tax return.
This applies to those who sold or spent their cryptocurrency, those who traded one cryptocurrency for another, and those who engaged in other taxable events, such as earning interest on cryptocurrency. , in 2021. Anyone who has simply bought and held a cryptocurrency will not yet be liable. .
Although the tax bill can sting, it’s important to report accurately and not attempt to underestimate your income, warns accountant Shehan Chandrasekera.
Calculating the taxes you owe on your cryptocurrency and non-fungible token (NFT) activity can be tricky, especially if you have multiple wallets, use different exchanges, or don’t use any software to track your transactions. That’s why, “generally speaking, people are afraid of taxes,” Chandrasekera, who is also head of tax strategy at cryptocurrency software company CoinTracker, told CNBC Make It.
However, there are ways “to actively use the tax code to your advantage,” he says, which can be “a huge incentive.” This can make compliance “benefit-driven” rather than fear-driven, he says.
Here are three things “savvy investors” do, according to Chandrasekera.
1. Tax loss harvesting
Chandrasekera recommends a strategy called tax loss harvesting, where investors sell their cryptocurrency at a loss in order to offset their gains.
“The losses can be used to offset your crypto gains, stock gains, and even regular income. Instead of holding your positions underwater, you can sell them, buy them back, and reap the loss,” he says.
For this to work, investors need to know how much they bought their cryptocurrency for, known as the cost basis, so they can calculate the difference. This requires careful record keeping and can be difficult without the use of a reputable software tool that tracks your transactions for tax reporting. But if done correctly, it can create significant tax savings.
Keep in mind that you can only offset capital gains with the same type of losses, so long-term losses are used to reduce long-term gains and short-term losses are used to reduce losses. short term gains.
The cryptocurrency isn’t subject to so-called “wash sell rules,” so “you don’t have to wait 30 days to repurchase the same position,” Chandrasekera says.
Wash sale rules prevent investors from immediately repurchasing the same security after selling it at a loss. Although policy makers have proposed imposing wash sale rules on commodities, currencies and digital assets in the Build Back Better Act, the legislation failed to pass.
2. Understand the long-term and short-term capital gains tax rates
Investors should understand the difference between long-term and short-term capital gains tax rates, Chandrasekera says. Long-term capital gains are realized when an investor sells after holding an asset for at least 12 months, while short-term capital gains are realized when investments are sold in less than 12 months .
“Sophisticated investors are aware of the tax benefit you get when you sell your coins after holding them for more than 12 months,” he says.
Indeed, long-term capital gains tax rates are generally more favorable than short-term rates, which are generally the same as regular tax rates and range from 10% to 37%. Long-term rates, on the other hand, can be 0%, 15% or 20% depending on your taxable income.
And remember, if you are not selling crypto or participating in any other taxable event, you are not yet liable to pay taxes.
3. Highest in, first out method of accounting
Chandrasekera also recommends using the highest accounting method, first out (HIFO) to calculate capital gains and losses.
When you use HIFO, you first sell the cryptocurrency that has the highest cost basis to reduce the amount of capital gains you have to pay tax on.
Suppose an investor bought two bitcoins in 2017, one for $4,000 in September and another for $6,000 in October. If he sold one for $20,000 in 2020, he can use the HIFO method to report the $6,000 as the cost base, regardless of the bitcoin he sold. This would result in less capital gains being deposited.
Again, this requires very detailed record keeping. The Internal Revenue Service (IRS) sees this as a responsibility of investors and requires individuals to keep records “sufficient to establish the positions taken on the tax declarations”, according to its website.
Taxes — cryptocurrency-related or not — are complicated. To navigate, it can be helpful to work with a CPA who can guide you through the reporting process and help you plan for the future.
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