It's officially tax season, and if you were among the many trading cryptocurrency this past year, it's time to report your activity on your 2021 tax return.
This applies to those who sold or spent their cryptocurrency, those who exchanged one cryptocurrency for another and those who engaged in other taxable events, such as earning interest on cryptocurrency, in 2021. Anyone who simply bought and held cryptocurrency won't be liable yet.
Though the tax bill might sting, it's important to report accurately and not attempt to understate your income, warns certified public accountant Shehan Chandrasekera.
Calculating the taxes you owe on your cryptocurrency and nonfungible token (NFT) activity can be difficult, 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, tells CNBC Make It.
However, there are ways that you can "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 that "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.
"Losses can be used to offset your crypto gains, stock gains and even regular income. Instead of holding your underwater positions, you can sell them, buy back and harvest the loss," he says.
For this to work, investors must know how much they bought their cryptocurrency for to begin with, known as their 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 short-term gains.
Cryptocurrency is not subject to what are called "wash sale rules," so "you don't have to wait 30 days to buy back the same position," Chandrasekera says.
Wash sale rules prevent investors from immediately buying back the same stock after selling at a loss. Though policymakers proposed imposing wash sale rules on commodities, currencies and digital assets in the Build Back Better Act, the legislation has not been passed.
2. Understand long-term vs. 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.
"Savvy investors are aware of the tax benefit you have when you sell your coins after holding them for more than 12 months," he says.
That's because long-term capital gains tax rates are usually more favorable than short-term rates, which are typically the same as regular income 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 don't sell any crypto or engage in any other taxable events, you aren't required to pay taxes yet.
3. Highest in, first out accounting method
Chandrasekera also recommends using the highest in, first out (HIFO) accounting method to calculate capital gains and losses.
When using HIFO, you sell the cryptocurrency that has the highest cost basis first to reduce the amount of capital gains you need to pay taxes on.
Say 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 his cost basis, regardless of which bitcoin he sold. This would result in fewer capital gains filed.
Again, this requires very detailed record keeping. The Internal Revenue Service (IRS) see this as an investors' responsibility and requires individuals to keep records "sufficient to establish the positions taken on tax returns," according to its website.
Taxes — cryptocurrency related or not — are complicated. To navigate, it may be helpful to work with a CPA who can help guide you through the reporting process and help you plan for the future.
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