By Seth Wilks, Director of Government Relations, TaxBit
Another tax season has come and gone. Time to put taxes out of mind until next year, right? Wrong! We know that taxes -- and particularly crypto taxes -- are complex, and when you’re done filing your tax return the last thing you want to think about is taxes. However, savvy crypto investors know the importance of tax planning year-round to reduce tax liability, and in some cases, get a tax refund.
In this post, we’ll cover three simple strategies you can use now to lower your crypto taxes next tax season:
Take advantage of the crypto market’s volatility and harvest your losses
Donate or gift appreciated assets
Specify the HIFO (Highest In, First Out) accounting method
Use tax-loss harvesting to capitalize on crypto market dips
Anyone who invests in cryptocurrency knows all too well the volatility of the crypto market. While the ups and downs can trigger anxiety, there’s a way to use these market dips to your advantage with a strategy called tax-loss harvesting.
What is crypto tax-loss harvesting?
Tax-loss harvesting is a tax savings strategy in which you can sell cryptocurrency assets while in a loss position to offset your capital gains, and therefore reduce taxes on cryptocurrency gains.
How does crypto tax-loss harvesting work?
To understand how to use this strategy, it’s important to familiarize yourself with the basics of cryptocurrency tax reporting. Whenever you dispose of an asset, you trigger either a capital gain or loss, which is taxed based on how long you held the asset and your income bracket. The cryptocurrency tax rates can vary from 0-20% for long term holdings and 10-37% for short term holdings.
Many crypto investors that are lucky enough to realize capital gains throughout the year find themselves faced with a rather hefty capital gains tax owed at the end of the year.
This is where tax-loss harvesting throughout the year comes in. It’s important to know that 1) capital losses can be used to offset capital gains and 2) wash-sale rules, which prevent a taxpayer from selling a security at a loss and immediately buying back, don’t apply to cryptocurrency. This means that when the market dips, you can sell your assets at a loss and buy them back to offset your capital gains.
An example of crypto tax-loss harvesting:
Let’s say you’ve sold a few coins throughout the year at a profit and are currently sitting at $10,000 in capital gains. At the same time, you’re holding crypto at a loss of $5,000. At this point, you have unrealized losses and could apply the tax-loss harvesting strategy by selling your crypto at the loss. This loss would offset your capital gains by $5,000, therefore reducing your tax liability by half.
End of year tip: If you experienced more capital losses than gains, you can claim the capital loss deduction and deduct up to $3,000 of capital loss to lower your ordinary income in any given year. Any remaining losses can be applied to the following year to offset future gains or lower your ordinary income by up to $3,000 again.
TaxBit’s Tax-Loss Optimizer makes it easy to apply tax-loss harvesting to reduce the taxes owed on cryptocurrency gains by automatically recommending a tax-optimized trade. With TaxBit, you not only have a trusted source to quickly calculate your taxes, you have a resource throughout the year to empower you to make informed trades and remove the burden of cryptocurrency taxes.
2. Donate or gift appreciated assets to avoid the capital gains tax
As mentioned above, you have to pay the capital gains tax on cryptocurrency when you sell or trade your tokens for profit. However, per the IRS’s guidance, you do not have to pay the capital gains tax when donating or gifting cryptocurrency.
Additionally, donations of crypto to a qualified charity are eligible for the itemized charitable deduction. It’s important to note that the IRS distinguishes gifts vs. donations to qualified charities. To claim this deduction, be sure you’re donating to a qualified charitable organization.
To get the most tax-savings out of your donations, we recommend donating your crypto assets in the following order of preference:
Long-term appreciated assets—avoid the capital gains tax and deduct the fair market value of the crypto at the time of the donation!
If you don’t have long-term appreciated assets then you should prioritize short-term assets that have not appreciated much—you still avoid the capital gains tax but you can only deduct up to your cost-basis.
If you don’t have any appreciated assets, then your last pick should be short-term assets that are in a loss position. However, it’d be more tax beneficial for you to harvest these losses in this case, as mentioned above.
3. Specify the HIFO cost basis accounting method
Your taxable capital gains or losses are calculated by the difference between the cost-basis, or the price you bought the asset at, and the price you sell the capital asset at.
Capital Gains = Sale Price - Cost Basis
But what if you could specify which crypto asset you wanted to sell in order to lower your capital gains and therefore the taxes you owe?
Per the IRS’s guidance, this is completely possible. The two cost-basis assignment methods allowed for cryptocurrency are First in First Out (FIFO) and Specific Identification.
FIFO is pretty straightforward: as the name implies, the first assets you purchased will be the first assets disposed of. This can be fairly limiting, however, and doesn’t always allow for the most tax optimization opportunities.
That's why we’ll be focusing on the Specific Identification (SpecID) method when discussing crypto tax savings. SpecID allows you to specify which assets you are disposing of, which is a great strategy to help you lower your crypto taxes. In order to get the most crypto tax savings, you can follow the Highest In, First out (HIFO) accounting method to specify the assets you want to dispose of.
How does HIFO work?
As the name suggests, HIFO accounting method prioritizes disposing of assets with the highest cost basis first. Looking at the capital gains formula above, we know that disposing of assets with a higher cost basis will reduce your capital gains and your tax liability.
For example, let’s say you purchased one ETH on five separate occasions, and then sold two ETH a month later. Let’s take a look at how you would calculate your capital gains or losses from this transaction using both FIFO and HIFO accounting methods.
Bought 1 ETH at $1300
Bought 1 ETH at $1500
Bought 1 ETH at $3500
Bought 1 ETH at $2700
Sold 2 ETH at $3000 each
Capital Gain or Loss
($6000 - $2800) = + $3200
($6000 - $6200) = - $200
In the above example, if you were using the FIFO accounting method, you would calculate your capital gains using the first two ETH you bought (on 1/1 and 2/1). This means you would have $3200 of taxable capital gains ($6000 - $2800).
However, if you used the HIFO accounting method, you would pick the assets with the highest cost basis to dispose of, in this case the ETH bought on 3/1 and 4/1. In this example, you’d end up with a capital loss of $200 ($6000 - $6200). Instead of owing tax on capital gains, you realize a capital loss that can be used to offset gains and lower your taxes.
It’s important to note that the IRS expects you to apply whatever cost basis assignment method you choose consistently in future tax years. This means you cannot switch cost basis methods from year to year. Whichever method you choose you should feel comfortable using going forward into future tax years.
TaxBit supports specific identification and automatically disposes of a user's highest cost basis assets first. By selecting specific identification, you will realize less taxable gains by disposing of their highest cost basis assets first.
To recap, you can reduce your crypto tax liability by harvesting losses to offset gains, donating or gifting appreciated crypto, and specifying the HIFO accounting method when calculating your capital gains. We recommend using a crypto tax software like TaxBit to simplify this process, have real-time visibility into your crypto portfolio, and make tax optimized trades year-round. Get started now with 10% off.
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