How Cryptocurrency is Taxed

Cryptocurrency has grown in popularity amongst investors, news outlets, and mainstream culture in recent years. Bitcoin, the first and most popular cryptocurrency reached a total market cap of over $1 trillion in early 2021.

Investors who held onto their Bitcoin and other cryptocurrencies throughout the crypto boom saw increases to their net worth, and now boast large capital gains profits. Now, the question amongst many investors is how to pay taxes on their earnings. In particular, what if you convert your cryptocurrency into physical dollars, goods, or services?

For federal tax purposes, the IRS considers cryptocurrency to be “property.” With this classification, cryptocurrencies are treated as a capital asset. This means you pay cryptocurrency taxes as if you sold some sort of capital. For example, when you sell your house and have to pay taxes, the IRS considers the difference between the original purchase price of the house and the net sales proceeds.

When paying taxes on cryptocurrencies, the calculation is similar. Begin by considering the difference between the original purchase price and the sales price. But there is an important next step, taxes owed on cryptocurrencies are largely dependent on the length of time the investment was held. Depending on the length of time you held your cryptocurrency, your gains will be considered either short or long term, effecting the amount of taxes owed.

(1) “Short-Term” Capital Gains or Losses – If cryptocurrencies are bought and sold within a 365-day window, you are taxed under the short-term bracket. Short-term gains are taxed at the same rate as your typical income, including wages, salaries, and commissions. This means that depending on your total net income, you may owe anywhere from 10% to 37% of your total income.

(2) “Long-Term” Capital Gains or Losses – If cryptocurrencies are bought and sold after a year, the difference between the purchase and sales price is taxed based on long-term tax rates. In general, you will pay less taxes on a long-term gains than short-term. As of 2021, there are three tax brackets for long-term gains, which you fall in is dependent on your total net income: 0%, 15%, or 20%.

How to Reduce Cryptocurrency Taxes

Considering the above ways in which cryptocurrencies are taxed, there are a few strategies to mitigate the amount you may owe.

            First, consider holding your cryptocurrency for over a year, so short-term gains are turned into long-term gains. It may be tempting to sell quickly, but take the potential tax differences into account before deciding to let go of your currency.

            Second, consider selling your cryptocurrencies during a year when you made less than usual. Paying during low-income years ensures you stay in the lowest possible tax bracket.

Finally, consider moving to a state without income tax. While this post has focused predominantly on federal income tax, states also have an interest in your investment earnings. Luckily, select states offer no income tax or significantly lower income tax levels, including Florida, Wyoming, and Delaware.

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