By Trevor English, VP at Ledgible
Key takeaways
- Cryptocurrency investors have several options to defer or avoid taxes
- Investment holding periods and transaction types significantly affect tax liability
- Tax rules can vary widely across jurisdictions
Nobody likes paying too much in taxes, including cryptocurrency investors. Different crypto transactions produce different tax consequences, and how long you own a digital currency usually matters.
Traders, investors, and crypto users alike can benefit from strategies to minimize their crypto taxes. Keep reading to explore seven ways to do just that.
1. Buy and hold cryptocurrency
Purchasing and not selling a digital asset generally incurs no tax liability. Buying and holding—or HODLing, for crypto natives—is the most conservative strategy for a tax-averse investor.
Cryptocurrency held in an investment portfolio may gain value, but this value is accrued on a tax-deferred basis. No tax liability is generated until the assets are withdrawn and their fair market value is assessed.
An investor who eventually withdraws cryptocurrency from their portfolio is likely to be taxed. Investors who buy and hold digital currencies for more than a year are generally subject to the long-term capital gains tax, which is a favorable rate for many taxpayers.
2. Invest in tax-advantaged accounts
Contributing money to a tax-advantaged retirement plan is another strategy that can minimize your crypto taxes. Individual retirement accounts (IRAs) and 401(k)s are two common investment structures that can potentially hold digital assets.
An IRA or 401(k) that is self directed is typically qualified to invest in cryptocurrencies. Self-directed retirement plans are permitted to hold a wide variety of assets, inclusive of real estate and precious metals. A retirement fund that’s self-directed usually has additional administrative requirements.
An investor in a tax-advantaged retirement plan may receive tax benefits either in retirement or the year when a contribution is made. Retirement accounts that yield tax breaks almost always have restrictions, which may be related to annual contributions, annual income, or annual withdrawals.
3. Practice tax-loss harvesting
Another strategy that may reduce your crypto taxes is tax loss harvesting. This advanced tax minimization strategy involves selling underperforming assets at a financial loss to lower your overall tax bill.
Tax loss harvesting is a complicated strategy because investors need to understand all applicable tax regulations, including any rules related to the nature and timing of your crypto transactions. Harvesting tax losses also requires being generally knowledgeable about investing, and it probably helps to have a view on current market conditions.
If you’re invested in one cryptocurrency that’s massively outperforming, then you can perhaps consider selling the weakest performers in your portfolio. Any losses that you report are used to directly offset your capital gains.
4. Invest through a legal entity
Investors with an appetite for paperwork and legal complexity can consider reducing their crypto taxes by forming a separate legal entity. A limited liability company (LLC), corporation, partnership, or trust may be used to potentially minimize or eliminate your crypto tax burden.
Transacting with digital assets through a legal entity can help an investor to reduce their tax liability by aligning the legal entity structure with the investor’s individual financial goals and tolerance for risk. The owner of a legal entity may benefit from a lower corporate tax rate or opportunities to offset crypto capital gains with business-related expenses.
Even professional investors are strongly advised to seek advice from legal and tax experts before using a separate legal entity to avoid crypto taxes. Laws and regulatory guidelines can be complex and in conflict across jurisdictions.
Forming, operating, and managing a separate legal entity also requires specialized knowledge and skill. The obligation to stay in regulatory compliance can feel burdensome if accounting is not your full-time job.
5. Gift your cryptocurrency
A somewhat straightforward way to avoid paying taxes on digital currency is to give your crypto away. Gifting cryptocurrency to friends and family or donating it to charity are two options to potentially reduce your crypto taxes.
Investors who donate cryptocurrency are generally not liable for capital gains taxes on the donated assets. And giving to a philanthropy that’s registered as a 501(c)3 nonprofit organization may provide additional tax benefits—that’s because crypto holders can potentially claim a tax deduction based on the fair market value of donated assets.
Cryptocurrency holders may face some restrictions on how much crypto they can give. Digital asset recipients may need to meet specific requirements, and some additional reporting might be necessary. Investors wishing to donate cryptocurrency to reduce their tax bills are advised to consult a tax professional before using this tax minimization strategy.
6. Move to a favorable tax jurisdiction
Digital asset holders wishing for a change of scenery can consider relocating to somewhere with favorable tax rules. This strategy for reducing your crypto taxes is the most logistically complicated, but may confer significant tax benefits depending on the jurisdiction that you choose.
Countries, states, and cities worldwide have widely varying laws and regulations for digital assets. Some jurisdictions provide generous tax breaks to attract crypto companies and investors, while others have relaxed rules and requirements.
Crypto investors seriously considering a physical move need to consider all of the ramifications of this choice. An investor living abroad may still have tax obligations in their country of origin—and moving to a new place typically has major personal and professional implications.
7. Use a specific identification method
Crypto holders with advanced accounting skills—or a crypto accounting specialist on hand—can consider using a specific identification method to minimize their crypto taxes. Some jurisdictions, the United States included, permit taxpayers to specify the particular assets being sold when calculating capital gains or losses.
Different crypto assets in your portfolio can produce different tax consequences, depending on how much you paid for the asset and when you bought it, among other factors. Using the FIFO—first in, first out—method is standard practice among tax and accounting professionals, but crypto investors wishing to minimize their taxes can opt for a more selective approach. Specifying only assets for tax reporting that you’ve held for more than a year, or those with the highest cost basis, are examples of specific identification accounting.
As with any advanced tax minimization strategy, using a specific identification method requires detailed record keeping. Investors need to track purchase and sale dates, transaction amounts, and other pertinent information. Consulting with a professional or using specialized crypto accounting or tax software can help even beginner investors to reduce their tax burdens.
