How crypto taxes work
The IRS classifies cryptocurrencies and other "virtual currencies" as property. As a result, you must report any cryptocurrency you receive as "income" and pay "capital gains" on any increase in value upon sale. It is not worth the risk of hoping the IRS doesn't notice your crypto income or profits. You should always report it!
The first section you should pay close attention to on your Form 1040 tax return is the virtual currency question at the top. While you can check "no" if you've merely owned virtual currencies, you must check "yes" if you have received or exchanged/sold virtual currencies during 2022. Inaccurately answering this question can lead to problems down the road.
Then, there are a few steps to calculate your crypto taxes:
Aggregate Transactions – The amount of tax you owe depends on your total capital gains. But, to compute your capital gains, you must have a chronological list of transactions across all your wallets and exchanges (if you use multiple).
Complete Form 8949 – You must report each cryptocurrency sale or exchange on IRS Form 8949, including the cost basis, sale price, and capital gain or loss. Then, you add the total to determine your overall capital gain or loss for the year.
Complete Form 1040 Schedule D – The final step is to carry over the overall capital gain or loss from Form 8949 onto Form 1040 Schedule D. Then, you can continue completing the rest of your taxes to see how much you owe or get back overall.
When completing Form 8949, you can use the default first-in, first-out (FIFO) cost basis method or match purchase and sale transactions using the specific identification method (e.g., LIFO or HIFO). For more information about these accounting methods, see our Tax Accounting Methods: How to Calculate LIFO And FIFO post.
Of course, if you receive cryptocurrency as compensation (e.g., mining), you must also report the income on Form 1040 Schedule 1 (for hobby income) or Schedule C (for business income).
Crypto taxes in Arizona
Arizona follows federal tax guidelines regarding cryptocurrencies, considering them as property subject to capital gains tax upon sale. Therefore, if you sell cryptocurrency in Arizona for a profit, you'll likely owe both federal and state taxes on the gains. It's essential to consult with a tax professional to ensure compliance with Arizona's tax laws regarding cryptocurrency transactions.
How & when to file taxes
Several people complete their taxes with the help of a CPA or other tax professional. Alternatively, you can use online tax filing services like TurboTax if you have a relatively simple situation. Zenledger has tax professionals who can help with your crypto taxes, or, if you choose the latter option, ZenLedger provides a TurboTax integration that makes it easy to complete your crypto taxes accurately.
The deadline to file 2022 taxes without penalties is April 15, 2023. While an automatic six-month extension is available to anyone for free, you still have to pay taxes you owe by April 15 to avoid penalties. If you fail to file your taxes or request an automatic extension, the IRS charges a Failure to File Penalty equal to 5% of your unpaid tax every month (up to 25%).
You can file Form 4868 to request an automatic six-month extension if you need more time, but you must still make an estimated payment of at least 90% of your total tax or 100%/110% of your prior year tax liability (depending on your income levels) to avoid Failure to Pay Penalties.
If you fail to make an adequate payment, the IRS charges a monthly Failure to Pay Penalty equal to 0.5% of unpaid taxes, up to a maximum penalty of 25%. However, you can avoid paying these fees if you demonstrate reasonable cause, including paying at least 90% of your total tax due or 100%/110% of your prior year tax liability (depending on your income levels) by April 15 and the balance with your return.
Since the Failure to File Penalty is much greater than the Failure to Pay Penalty, it always makes sense to request an extension, even if you cannot afford to pay your taxes by April 15. And you can reduce your penalties by paying what you can afford by April 15.
The IRS does not charge any penalties if you are getting a refund.
Tax planning strategies for crypto traders & investors
Now that we’ve covered the basics, let's look at a handful of specific strategies you can use to cut down on your tax liability each year.
1. Hold more than a year
Want to cut your tax bill by up to 12%? It's easy: Hold an asset for longer than a year before selling it. Doing so will generate long-term capital gains taxable at a lower rate than short-term capital gains.
Suppose you earn over $170,000, pushing you into the 32% tax bracket, and you decide to sell $10,000 in Bitcoin. If you've held the Bitcoin for less than one year and sold it, you will owe $3,200 in tax on the $10,000 gain. But if you sell after holding the Bitcoin for one year, the tax bill drops to $2,500—a $700 or seven percent savings.
2. Harvest tax losses
Nobody wants to lose money on crypto investments. But if you do, be sure to harvest your tax losses. By selling a losing position, you can realize the loss and use it to offset other capital gains or up to $3,000 in ordinary income each year. And if you can't use it this year, you can carry the loss over into future years.
Even better, unlike the stock market, crypto assets don't fall under the so-called wash sale rule, which prevents you from immediately repurchasing the asset after realizing the loss. So, you can instantly replace the coins in your portfolio after realizing the loss. As a result, it makes sense to always look for opportunities to harvest losses throughout the year.
However, there’s no guarantee that tax loss harvesting will stick around forever. In fact, Biden’s new budget plan could close the crypto tax harvesting loophole if approved.
3. Sell during low-income years
Your tax rate typically depends on your income. So, another way to reduce your tax burden is to sell during low-income years when your tax rate is lower—especially when it comes to short-term capital gains.
For instance, suppose it's December and you have an Ethereum position you've held for six months. If you plan to earn less next year (maybe you’re retiring or switching jobs), you might wait to sell until January 1st in order to realize a lower tax rate.
4. Use an SDIRA
Most IRAs and other retirement accounts don't permit crypto assets. But a particular type of IRA, a self-directed IRA, or SDIRA, does. By holding crypto in an SDIRA, you can defer taxes until you sell or pay taxes immediately and avoid paying tax on any capital gains.
SDIRAs provide the same tax benefits as conventional IRAs but may cost more to set up and operate over time. So, talking with a tax professional is critical to determining if it's the right fit for your situation.
5. Gift crypto to family
Many people financially support their children or other family members at some point. But gifting crypto rather than cash can help you lower your tax bill and provide the same support.
The IRS allows individuals to gift up to $15,000 per share, per recipient, without incurring any gift tax. Of course, there are a few rules. For example, you must still pay capital gains taxes if you gift crypto to children under 18 since the IRS views that as taxpayers trying to use a loophole. So consider speaking with a tax expert before using the strategy.
6. Donate crypto to charity
Do you donate to charity? If so, donating your crypto assets instead of cash can help you realize a double tax break.
If you itemize your tax return, you can deduct your charitable contributions, and you will not owe any capital gains taxes on the appreciation of your donated assets. At the same time, the charity won't have to pay capital gains taxes, so it's a win-win for both parties.
7. Move to a low-tax jurisdiction
Remote work has made moving more manageable than ever. And some moves can significantly reduce your tax burden, especially when it comes to crypto assets.
Alaska, Tennessee, Wyoming, New Hampshire, Florida, South Dakota, Texas, Nevada, and Washington have no state income tax. Depending on where you’re moving from, that could save you thousands of dollars annually. That said, states like New Hampshire still tax some interest, and other exceptions exist. So, it's essential to do your due diligence before packing up.
Handling tax liabilities
You made many wise investment decisions over the past year and are now facing a huge tax bill as a result of the capital gains that you locked in. How do you deal with this? At Arch, we’ve spoken to many customers with this problem and wanted to highlight potential paths to take below:
Paying with cash: If you have excess cash that you can use to cover your liability this is a good option. Note that even if you aren’t able to cover the full tax bill, it may make sense to pay down as much as you can with cash so that you minimize the amount you need to cover via non-cash means, which may come with fees or other consequences. The one caveat with this approach is that you are giving up optionality as you won’t be able to use this cash for any investment opportunities that may arise.
Selling assets: If you have other assets such as crypto or stocks, you can sell these assets and use the proceeds to pay off the tax liability. If you no longer believe in the upside of these assets, then this can be a good option. If these assets happen to be valued below their cost basis (price at which you acquired them), this also represents an opportunity to offset any capital gains for the next season. If the assets are valued above their cost basis, this will result in additional capital gains for the next season, which may be especially painful if it’s short-term or you have a strong conviction in the future growth.
IRS payment plans. Individuals can choose from a long-term installment plan or a short-term, 120-day payment plan. For those needing just a little extra time to pay their taxes, the short term plan may be a good option. IRS does not charge any fees, but interest and penalties will continue to accrue until you fully pay off your tax debt. If you can pay off earlier than 120 days, it’s a good thing to do so. The longer term payment plan comes with a setup fee, and has to be approved by the IRS.
Take out a loan: The IRS suggests taking out a loan as an option in the event you cannot pay your tax bill in full with cash. There are a variety of ways to get a loan, starting from asking family and friends, to a personal unsecured loan online, to a secured loan backed by your own assets (real estate, stocks, or even crypto). The exact terms of one’s loan depend on a variety of factors, but generally there is an interest rate charged from the provider, and additional fees such as those for the loan origination may apply.
If possible, it’s always better to plan ahead for tax season to avoid the financial stress that comes with not having enough to cover the tax bill. That is of course easier said than done, so hopefully this has shed some light on the options for those in need of help.
The information provided here is for educational purposes only and should not be construed as financial or legal advice. Tax laws and regulations can vary, and the tax implications of cryptocurrency transactions may be complex. It is highly recommended that you consult with a qualified tax lawyer and/or accountant to assess your specific situation and ensure compliance with applicable laws and regulations.