How Cryptocurrency Is Taxed, and How You Can Avoid It
Updated: Feb 14, 2022
This post is for entertainment purposes only. For individual tax or investment advice, please contact a professional. The author of this post has long financial positions in Bitcoin and Ethereum.
The Pain of Crypto Taxes
It's no secret that cryptocurrency as an asset class is beginning to gain steam in the mainstream, seeing the duopoly of Bitcoin and Ethereum recently hitting all-time highs. CNBC's annual millionaire survey found that a record number of millionaires now hold some form of cryptocurrency, mostly Bitcoin. It's becoming easier for normal people to now own a piece of the digital currency future thanks to the ease of use of platforms like Coinbase or Gemini, downloadable on your phone in just a few minutes. Additionally, the new world of stablecoins is taking shape as people want higher interest rates than the 0.50% they're getting from a high-yield-savings-account, so they're looking to assets like USDC to get them 4-8% a year in a crypto-asset that doesn't move. Finally, there's the reasoning that Bitcoin could continue its run as the hottest investment in the world, with some positing that it could reach over $5 million per coin by the end of the decade. However, with every top-performing asset class, there comes a dark side: taxes.
According to the IRS, cryptocurrency in the U.S is considered "property" and not "currency." This is an important distinction in the world of taxes because you are taxed on how that asset is eventually "realized." This means that you're taxed during the actual acquisition or use of the asset, rather than being hit with capital gains if you just buy and hold. Think of it like a stock when you sell, except in this case, you can teach your computer to mine the stock for you. And just like a stock, you can claim capital losses on your taxes up to $3,000 to offset any other capital gains, but you're also subject to the same short-term/long-term capital gains scale that any other security is, which could soon look dramatically different with the current congressional proposals around unrealized capital gains. As a bizarre final point, NerdWallet is quick to point out that new rules around cryptocurrency theft. Previously, you'd be able to deduct this as a theft loss from your total capital gains bill. Now, however, due to changes in digital tax law, personal theft losses are no longer a thing, counting against your total tax bill for the year. Ouch.
But there's another side to the tax story. Every year, you hear about millionaires and billionaires avoiding hefty tax bills through loopholes, both legal and....legal-adjacent, let's call it. Today, I want to take you through a few tax tips that you can borrow from the 1% to minimize the impact your sweet, sweet crypto gains have on your fiat checking account.
1. The Wash-Sale Rule
If you handle your traditional investing with a financial advisor (please stop doing that and just buy an index fund), then any advisor worth their salt will call you up around tax time and inform you that it's time to tax-loss-harvest. What this means is to sell your losers at a loss in order to claim back capital losses to offset capital gains. It's essentially a strategy to mitigate the tax bill you might incur from short-term capital gains, which are a bitch. However, there's a catch: you cannot repurchase the same asset within 31 days of selling if you want to count the loss towards your TLH. This is called the Wash-Sale Rule, and it is critical in correctly executing capital losses.
In crypto, this rule doesn't currently exist. This means that if you take a short-term capital loss on Bitcoin, you can sell at a lower price and immediately buy it back, with your loss still counting towards mitigating your tax bill. While it would be tough to find many losers in Bitcoin or Ethereum this year, you could take advantage of this rule if you were invested in, say, Shiba Inu Coin.
The token has seen a remarkable 73 million percent gain over the past 12 months, but the bottom has fallen out in the last 10 days. So assuming you bought at the top and have seen it crash back to earth, you could sell at your loss and immediately buy back in if you believe in the future of the coin. This loss will still count towards offsetting your capital gains for any other crypto you've seen realized gains on for this tax year.
I will point out that this strategy likely has the shortest shelf-life on this list. In an attempt to find funding for the $3.5 trillion "Build Back Better" plan currently working its way through Congress, Democrats have suggested closing this loophole in order to generate more tax revenue, to the tune of about $17 billion. That's why this rule was included in the legislation currently en route to President Biden's desk for signature, giving crypto holders until January 1, 2022, to take advantage.
2. Buy Crypto In A Retirement Account
That's right: you too can go full "Peter Thiel" and absolutely leverage legal investment accounts to your heart's content. I already wrote a full article on the different types of retirement accounts here (go read it, it's good), so I won't spend time here outlining how an IRA is different than a Roth IRA, but suffice to say that they're both powerful tools for retirement planning. And now, there are several different ways to get cryptocurrency exposure inside of your retirement accounts!
The first way to do this is to find a Crypto IRA custodian. A popular one at the moment is iTrustCapital (not sponsored), which allows you to swap cash for crypto inside of an IRA to provide retirement benefits on your cryptocurrency. You can also do this with gold, oil contracts, etc, but cryptocurrency is the name of the game here. As an added benefit, directly contributing to a Traditional IRA will lower your reported taxable income as the money goes in pretax, meaning you're getting a traditional cash tax benefit in the process. Using this process in a Roth IRA? Well that could be even better because you could potentially pay 0% in taxes when you withdraw your crypto gains after age 59.5. Now you're thinking like the 1%!
The second way to do it is much easier, and you can do it yourself with the accounts you likely already have open. This is all thanks to the recently approved and unveiled Bitcoin ETF market. October 19, 2021, saw the first trading day of the ProShares Bitcoin Strategy ETF after the U.S Securities and Exchange Commission greenlit the fund. While it's not direct exposure to Bitcoin itself (it's based on Bitcoin futures contracts, rather than physically owning the asset), it could pave the way for direct-exposure ETF's that are akin to directly owning Bitcoin. Should this happen, it would be as easy as buying the ETF in your self-directed retirement account, potentially slamming the door on crypto taxes in your future.
The third way to do this is to purchase publicly traded companies that have direct exposure to cryptocurrency or blockchain assets. The most notable companies at the moment are Riot Blockchain, Coinbase and MicroStrategy.
You'd be hard-pressed to find a bigger Bitcoin-bull than MicroStrategy Founder and CEO Michael Saylor, who has levered up the balance sheet of his company to reflect a massive stake in Bitcoin, so owning this company inside of a retirement account could effectively be a play into owning Bitcoin via a publicly traded company inside of a tax free account. #RichGuyStuff
3. Donate to Charity
Ah, yes. The classic "old, rich, white guy" strategy. It's a tale as old as time: Buy something, hold it while it goes up, then shoot it to an orphanage or, better yet, a charity that you own with your name on it, then deduct that amount from your taxes at the cost of the asset. According to Fidelity Charitable, a donation of cryptocurrency to a 501(c)(3) organization will see a tax deduction equal to the fair market value of the donated token. This means that if you were to donate one whole Bitcoin to charity right now, you would essentially see a $66,000 deduction.
4. Get Paid In Bitcoin
If you've searched finance Twitter for even a few minutes, you've likely seen Bitcoin-oriented accounts tweeting about the recent influx of public political figures now opting to take their salary in Bitcoin. Even some NFL players are getting in on the act (though Aaron Rodgers really buried that news with his own drama this week). But why are they getting paid in Bitcoin, rather than getting paid in a normal way and then buying Bitcoin afterwards? Taxes! And PR, but mostly taxes.
Incoming New York mayor Eric Adams announced that he will take his first three paychecks in Bitcoin, seemingly to one-up Miami's mayor who announced his next paycheck will be in the digital currency. While this seems to be a competition between New York and Miami to outrace each other to the blockchain talent pool, it's also an opportunity to review the differences in capital gains taxes versus income taxes.
Miami is an excellent chance to do this. Your short-term capital gains tax rate will vary depending on your income, generally falling anywhere from 10%-37%. However, why do many athletes claim residency in the state of Florida? No state income tax! That means that if you are a Florida resident who takes their income in Bitcoin, you are essentially receiving Bitcoin without that bite taken out by the government. "Florida man gets paid in Bitcoin" might be the one positive "Florida man" story we've ever had.
5. Buy Yourself a New Citizenship
OK, now we're really into true rich-guy evil villain territory. Did you see the most recent episode of "Billions" where Bobby Axelrod runs off to Switzerland with $2 billion in the bank and no more worries? Well, that's actually possible for you too, depending on how much cryptocurrency you actually own. Let me explain.
There are currently seven countries around the world that have a 0% tax rate on cryptocurrency: Saint Kitts and Nevis, Antigua and Barbuda, Dominca, Vanatu, Grenada, Saint Lucia and Portugal. Many of these companies offer what's called a "citizenship-by-investment" scheme, which incentivizes foreign nationals to make investments into the country. In exchange, those people are rewarded with citizenship to that country, and are free to take advantage of their pretty liberal tax laws.
This is not the shady "hop on a biplane and fly under the radar" strategy it sounds like. There are now purpose-built companies to help wealthy crypto investors gain secondary citizenship for the sole purpose of dodging digital asset taxes. Plan B Passport is the newest kid on the block, with founder Katie Ananina working with "hundreds of people a year" to gain tax-avoidance citizenship to these tax havens. These passports don't come cheap, however.
“It’s basically a donation into the sustainable growth fund of the country. So, clients make a $100,000 or $150,000 donation, plus some due diligence fees, government fees, and then $20,000 for my legal fees.” - Katie Ananina, in a statement to CNBC
It's worth clearly stating that this strategy is not tax evasion, at least in a legal sense. But the IRS is getting wise to this strategy and are now pursuing U.S nationals that look to employ this strategy around the world. The Foreign Account Tax Compliance Act has effectively given the IRS global power to pursue U.S tax payers who pursue secondary citizenship to hide their capital gains. It will also likely soon be harder to move cryptocurrency due to a newly proposed cryptocurrency reporting structure by the U.S Treasury, putting legal onus on the banks and exchanges used in the movement of the assets. But if your checkbook is big enough, there are services out there to cater to you if you're looking for that secret second passport. Good luck explaining your secret life to your significant other, though.
The Bottom Line
It's again worth stating that none of the information enclosed in this piece is advice on how to evade taxes. I would always advocate paying your taxes so you don't get in trouble with the IRS. That being said, the rich have a playbook that normal people like you and me just don't have access to, so I hope that this helped open your eyes to some out-of-the-box ideas to mitigate your tax bill. And to any SHIB millionaires out there who grabbed a second passport in Portugal, how about shooting me a bottle of wine as a "thank you?"
Do you own any cryptocurrency in your portfolio? Would you consider a second passport to lessen your tax bill? Let me know in the comments below! And don't forget to sign up for my email list so you get these in your inbox as soon as they post. Thanks for reading!