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Cryptocurrencies are a relatively new concept. Because of this, investors typically have many questions regarding the way they work, especially when it comes to taxes. One of the most common questions regarding crypto is, “do you pay capital gains on crypto?”
Like traditional stocks, crypto is taxed as property and subject to capital gains and losses. Depending on how long you hold your cryptocurrency before disposing of it, you’ll either be taxed at the short-term capital gains or long-term capital gains rate.
Below, I will discuss how exactly capital gains and losses work regarding cryptocurrency. Keep reading to get ready for tax season!
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What is Crypto?
Commonly referred to as simply “crypto,” Kevin Voigt and Andy Rosen at NerdWallet define cryptocurrency as “a digital asset that can circulate without the need for a central monetary authority such as a government or bank.”
Essentially, crypto is a type of virtual currency. Blockchain cryptography secures crypto transactions, logging each anonymously on an accessible web page that acts similarly to a checkbook.
Because there is no central bank that oversees the crypto market supply, it relies solely on digital lenders to secure and verify the transactions.
Is Cryptocurrency Subject to Capital Gains?
Because cryptocurrency is not backed by any federal government, it’s subject to significantly fewer regulations than traditional currency. Some people believe that this means it’s not subject to taxation.
However, this is unfortunately a misconception. While you will not have to pay income tax on any cryptocurrency you buy, trade, or own, it is subject to capital gains and taxed as property, similarly to traditional stocks.
You must pay capital gains whenever you use cryptocurrency to sell, trade, or purchase goods or services.
How Much is Crypto Taxed?
In the United States, cryptocurrency is taxed as property, or a “capital asset.” Crypto exchanges are required to report gain and loss activity to the IRS, so you’ll file any cryptocurrency transactions as either a capital gain or capital loss.
The amount you’ll be taxed for these gains depends on your holding period (how long you’ve held the cryptocurrency) and your income tax rate. Depending on how long your holding period is, you may pay either the short-term capital gains rate or the long-term capital gains rate.
Short-Term Capital Gains Rate
Some people purchase cryptocurrency, then quickly dispose of it through selling, trading, or using it to purchase goods and services. If you hold onto your cryptocurrency for less than 12 months before disposing of it, any profits or gains will be taxed at the short-term capital gains rate.
This rate is equivalent to your traditional income tax rate. Depending on the amount of money you make per year, this rate could range anywhere from 10% to 37%.
To calculate how much you owe, you’ll add the amount of money you profited from cryptocurrency transactions to your annual income. Then, deduct your usual income tax rate.
In addition to cryptocurrencies you’ve held for less than one year, any income you’ve earned in the following ways are subject to your typical income rate:
Long-Term Capital Gains Rate
While some investors dispose of their cryptocurrency in some way relatively quickly, others hold onto it for a longer period. If you held your crypto for over one year before deciding to sell, trade, or use it to purchase goods or services online, it will be taxed at the long-term capital gains rate.
Long-term capital gains are taxed separately from your traditional income, at a rate of 0%, 15%, or 20% depending on your annual income and tax filing status.
Because these rates are typically lower than the short-term capital gains rate, investors often choose to hold onto their cryptocurrencies for at least one year before disposing of them.
How to Offset Capital Gains on Cryptocurrency
When it comes down to it, no one enjoys paying taxes. Depending on how much you’ve profited through crypto over the past year, the amount you owe could be significant.
For this reason, many people seek legal ways to offset the capital gains they have to pay when tax season comes around. If you’re looking for a way to do this, you may want to try tax-loss harvesting or purchasing crypto using an IRA.
Let’s discuss what each option entails.
One of the most popular ways crypto investors offset their capital gains is through a process known as tax-loss harvesting. This approach allows you to sell crypto assets at a loss to offset those you’ve sold at a profit.
Any time you sell or trade cryptocurrency, it triggers either a capital gain or capital loss. The gain or loss you report is equivalent to the amount you receive from the disposal (the “proceeds”) minus the amount you initially purchased the asset for (the “cost basis).
If this process seems a bit confusing to you, you’re not alone. Here’s a great example from TaxBit that may help you understand the process better.
Let’s say you purchase $3,000 worth of Bitcoin. When you’re ready to sell, you could take advantage of a dip in the market and sell the same amount for $2,000.
Because your proceeds are $1,000 less than your cost basis, you’ll have a capital loss of $1,000 that you can then claim on your taxes. If you have any capital gains to report, this $1,000 loss could offset some of those gains, reducing the overall amount you owe in taxes.
Some investors harvest more often than others. It’s up to you to decide when it would be most beneficial, although most decide to do so annually. Check your assets for dips regularly during the last couple of months leading up to the new year.
According to Lance Cothern at Finance Buzz, you may be able to offset capital gains taxes by investing in crypto through a self-directed IRA. An IRA is a type of retirement account that comes with many tax benefits, depending on the type you contribute to.
Traditional IRAs will typically allow you to make tax-deductible contributions, including cryptocurrency contributions. However, you’ll still have to pay the usual income taxes once you retire and begin withdrawing money.
Roth IRAs, on the other hand, require contributions to be made post-tax. However, once you retire and begin withdrawing funds, you’ll be able to do so tax-free as long as you meet certain requirements.
Like stocks and other similar assets, cryptocurrency transactions are subject to capital gains tax. The exact rate you’ll be taxed at depends on how long you’ve held your virtual currency, as well as your annual income.
As a crypto investor, it’s important to understand how much money you’ll owe in capital gains before tax time comes around so you can prepare accordingly.