We all know the IRS is very slow with respect to addressing modern-day technology and basically anything that makes our lives as taxpayers “simple.” But with the 2019 tax season quickly upon us, the IRS recently announced January 27 as the official date for accepting tax returns for the 2019 reporting period.
However, for digital money or cryptocurrency holders, this year is one to pay attention to, because the IRS finally has something to say about it with respect to how you report your holdings.
For the first time since 2014, the IRS has issued new cryptocurrency tax guidance in the form of a complete cryptocurrency FAQ and an official Revenue Ruling: 2019-24.
How is “Virtual Currency” Treated for Federal Income Tax Purposes?
Back in 2014, the IRS issued Notice 2014-21, 2014-16 I.R.B. 938, explaining that virtual currency is treated as property for Federal income tax purposes and providing examples of how longstanding tax principles applicable to transactions involving property apply to virtual currency.
This year’s new Revenue Ruling expands upon the 2014-21 examples and apply those same longstanding tax principles to additional situations.
Understandably, many are dreading the process of gathering records for years of trading across multiple exchanges. But, if you’re one of those traders it’s not all bad news.
The New 1040 Schedule 1 Form
This year’s new 1040 Schedule 1 form now has a question regarding your cryptocurrency ownership, forcing crypto traders throughout the U.S. to report their cryptocurrency transactions for the very first time.
The IRS defines “cryptocurrency” as a type of virtual currency that uses cryptography to secure transactions that are digitally recorded on a distributed ledger, such as the Blockchain.
If you are selling virtual currency, the IRS now requires you to recognize any capital gain or loss on the sale, subject to any limitations on the deductibility of capital losses.
However, don’t fret yet. Not only are there strategies for minimizing taxes on your crypto gains, but there are also ways to use your crypto losses to offset your taxable income.
Here are three ways you can aim to reduce your crypto taxes for the 2020 reporting period.
DISCLAIMER: Please consult with a tax professional when discussing these principles.
#1 — HODL On Just a Bit Longer
If you’re paying crypto taxes for the first time this year you’ll want to be aware of the difference between how short term and long term gains are taxed.
Cryptocurrencies like Bitcoin are taxed as property, while assets held for longer than one year are taxed at a lower rate than short-term assets.
Capital Gains Tax Rate and Long-Term Holdings
If you held the virtual currency for one-year or less before selling or exchanging the virtual currency, then you will have a short-term capital gain or loss.
If you held the virtual currency for more than one-year before selling or exchanging it, then you will have a long-term capital gain or loss.
This means that if you are able to track how long you have been holding your crypto you can use this information to decide if you want to sell or hold on long enough to make the one-year mark.
#2 — IRS Wants You to Understand “LIFO” and “HIFO” As Costing Methods
Historically, most traders have opted to use FIFO (first-in first-out) to calculate their crypto capital gains or losses. But with the IRS’ newly issued guidance, traders now have the opportunity to use different, specific identification methods to minimize their tax liability.
The IRS has declared that specific identification methods like “LIFO” (last-in first out) and “HIFO” (highest-in first-out) as acceptable methods, so you can now look to better identify your assets. Changing the chronological order of how you calculate your crypto sales can make a big difference in the final result.
Applying “LIFO” and “HIFO”
Here’s an example of the potential savings you could see if you used “LIFO” or “HIFO,” instead of “FIFO.”
You buy 5 ETH on Coinbase on February 7, 2019 for $500 each.
On March 1 you buy 2 ETH for $700 and on March 7 you buy 4 more for $600 each. In July 2019 you sell 4 ETH for $2,400.
If you use FIFO to calculate the capital gain for this sale you will use the purchase price of the first 4 ETH acquired in February (4 * $500) and subtract it from the sale price $2,400.
$2,400 (fair market value) – $2,000 (cost basis) = $400 (capital gain)
If you use LIFO you can change the order and calculate a your cost basis with the last 4 ETH purchased in March (4 * $600)
$2,400 (fair market value) – $2,400 (cost basis) = $0 (capital gain)
LIFO is particularly effective for minimizing taxes during times of rising cryptocurrency prices, as the most recently acquired coins will have the highest value. And by selling off your oldest coins first, this method also extends the holding period for your most recently acquired coins, giving them a chance to reach the 1 year minimum to qualify for long-term capital gains rates.
Using HIFO, the coins with the highest cost basis will be sold first.
Thus, your cost basis for 4 ETH would be (2 * $700) + (2 * $600) = $2,600.
In this example the HIFO method was used to realize a cost basis ($2,600) that is higher than the sale price ($2,400), leading to a capital loss of $200.
From this example we can see the dramatic effect that specific identifications can have as you calculate your capital gains or losses:
- FIFO: $400 capital gain
- LIFO: $0 capital gain
- HIFO: $200 capital loss
The key to effectively using this strategy is to maintain clear records of when you bought each coin and the original purchase price.
However, it’s easy to lose track of the cost basis for a coin as you move it through multiple exchanges.
For example, if you purchased a coin on Binance, you may consider moving it to a cold wallet, and then transferring it to Coinbase where you make the final sale.
Why? Coinbase only recognizes that a coin has been transferred. They do not have any way of knowing the cost basis.
At the end of the year, Coinbase cannot give you the documentation you would need (cost basis and date of original purchase) to use LIFO or HIFO.
#3 — Tax Loss Harvesting
If you know that you’ve experienced some losses in your crypto portfolio this year you can use the volatility of the crypto market to your advantage with tax loss harvesting. This is a common strategy used with investors of stocks and securities, but crypto assets have a unique advantage that makes them even more strategic for minimizing your tax liability.
One method, known as “Tax Loss Harvesting” allows you to sell an asset at a loss in order to offset your capital gains.
You can declare up to $3,000 in net losses if you’re filing as a single individual or up to $1,500 if married and filing separately. Anything over those amounts can be carried over to the next year.
We’ll start with an example from the world of stocks.
You buy $1,000 worth of Microsoft stock and $2,000 of Apple in 2019.
Then, Microsoft rises to $2,000 and the Apple falls to $1,500.
You sell the Microsoft at $2,000 and now you you will be taxed on that $1,000 capital gain.
Applying Tax Loss Harvesting, you can offset that capital gain by selling your Apple for $1,500, and taking a loss of $500.
$1,000 (Microsoft gain) – $500 (Apple loss) = $500 (total capital gain)
Think about it. You just strategically sold an asset at a loss, and now you’ve cut your capital gains in half.
But what if you want to buy back that Apple stock and wait for it to appreciate? This is considered a “wash sale,” and pursuant to the SEC, there are rules (IRS Publication 550) that prohibit you from deducting losses in this scenario, or other words, rules that would prevent you from buying back that Apple stock within a 30-day window.
This is the point where cryptocurrencies present a unique opportunity, because the IRS has specifically stated that cryptocurrencies are “property not securities,” so wash sale rules do not apply to crypto assets at this time. Following that logic, that could mean you could technically sell a crypto asset at a loss, realize that loss to offset your capital gains, and then buy back the crypto right away.
Unfortunately, December 31 was the deadline to realize your crypto losses for 2019, but with this strategy in mind you can look forward to using Tax Loss Harvesting to offset your capital gains and to balance out any disappointment from under-performing crypto assets.
Do You Have a Headache?
Please keep in mind that you should still one-hundred percent consult with a tax professional when reporting your taxes. Don’t look to us. We are providing you with the insight so you can then discuss with your tax professional the options that may apply to your particular reporting period.
At the end of the day, these three-tactics above should provide you with plenty of motivation to begin collecting your tax records to help keep you pushing through the world of cryptocurrency.