3 ways savvy crypto investors use the tax code to their advantage

It’s officially tax season, and if you were among the many cryptocurrency traders last year, it’s time to report your activity on your 2021 tax return.

This applies to those who sold or used their cryptocurrency, those who exchanged one cryptocurrency for another and those who participated in other taxable events, such as earning interest on cryptocurrency, in 2021. Anyone who has simply bought and held cryptocurrency , will not be responsible yet.

While the tax bill may sting, it is important to report accurately and not try to underestimate your income, warns state-authorized public accountant Shehan Chandrasekera.

It can be difficult to calculate the taxes you owe on your cryptocurrency and nonfungible token (NFT) activity, especially if you have multiple wallets, use different exchanges or do not 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 firm CoinTracker, told CNBC Make It.

However, there are ways 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 harvest

Chandrasekera recommends a strategy called tax-loss harvesting, in which investors sell their cryptocurrencies at a loss to offset their gains.

“Losses can be used to offset your cryptocurrency gains, stock gains and even ordinary income. Instead of holding your underwater positions, you can sell them, buy back and reap the losses,” he says.

For this to work, investors need to know how much they bought their cryptocurrency to begin with, known as their cost base, so they can calculate the difference. This requires careful registration and can be difficult without the use of a reputable software tool that tracks your tax reporting transactions. But if done right, 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 so-called “washing sale rules”, so “you do not have to wait 30 days to buy the same position back,” says Chandrasekera.

Clearance sale rules prevent investors from buying back the same stock immediately after selling at a loss. Although policy makers proposed introducing laundering rules for raw materials, currencies and digital assets in the Build Back Better Act, legislation has not been passed.

2. Understand long-term versus short-term capital gains tax rates

Investors should understand the difference between long-term and short-term capital gains tax rates, says Chandrasekera. Long-term capital gains are realized when an investor sells after having had an asset for at least 12 months, while short-term capital gains are realized when investments are sold in less than 12 months.

“Wise investors are aware of the tax advantage you have when selling your coins after holding them for more than 12 months,” he says.

This is because long-term capital gains tax rates are usually more favorable than short-term rates, which are typically the same as ordinary income tax rates and range from 10% to 37%. Long-term interest rates, on the other hand, can be 0%, 15% or 20% depending on your taxable income.

And remember, if you do not sell crypto or attend other taxable events, you are not 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 you use HIFO, you first sell the cryptocurrency that has the highest cost base to reduce the amount of capital gains you have to pay tax on.

Let’s say one 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 could use the HIFO method to report $ 6,000 as his cost base, no matter what bitcoin he sold. This will result in fewer capital gains.

Again, this requires very detailed record keeping. The Internal Revenue Service (IRS) sees this as an investor’s 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 can be helpful to work with a CPA who can help you through the reporting process and help you plan for the future.

Sign up now: Get smarter about your money and career with our weekly newsletter

Do not miss: More regulation of cryptocurrency is likely – here are 3 ways to prepare now

Leave a Comment