How to be smart about taxes on bitcoin

March 27, 2021

Are you among the estimated 15% of Americans who own digital currency? If you sold or traded it last year, you're probably sitting on big gains, and those will come with hefty tax bills.

There are smart ways to manage those obligations, and not-so-smart ones, too.

Lots of crypto investors might be tempted to hide their heads in the tax-planning sand, and it's easy to see why. The tax issues are complex. Brokerage firms don't do the hard work of tracking their holdings, as they typically do for owners of stocks and bonds. Guidance from the Internal Revenue Service can be confusing, too.

Still, they can't afford to throw up their hands.

Just a few years ago, many taxpayers were simply unaware of the tax implications of trading Bitcoin or other digital currencies. In 2014, the IRS had said that crypto was considered property, like stocks, and would therefore be subject to capital-gains taxes when sold or traded. (If investors hold anything that's considered property for under a year, it's taxed at ordinary income tax rates. If it's held for longer, it generally qualifies for lower long-term capital gains tax rates.)

Now, the question is less, "Wait, I owe taxes?" and more about how to reduce the capital gains tax owed, or at least how to pay it later.

The main way now to defer crypto tax bills for 2020 is to invest in an opportunity-zone fund. A provision in the 2017 tax law allows taxpayers to defer, and even reduce, capital gains taxes if they put the proceeds from the sale of say, a stock or business, into a fund created to promote investment in an economically disadvantaged area. Investors generally have six months to move the money.

Proceeds from crypto sales qualify, too, according to Ryan Losi, an accountant in Richmond, Virginia. Those who sold crypto toward the end of last year can still cut their 2020 capital-gains tax bills by acting now.

Under the rules, they'll be able to defer their capital gains tax until 2026, and if they hold the investment beyond that, cut their tax bill by as much as 10%.

There are also some moves taxpayers should consider before taxes are due next year. Those who are philanthropically inclined and itemize their deductions may want to donate their gains to a charity (provided the nonprofit accepts crypto, although there are third parties that can help if not). That's doubly advantageous because the donor both escapes the capital-gains tax and gets a deduction for the full market value of the crypto holding up to a certain percentage of income, as long as it was held for at least one year, said Nicholas Marazza, an accountant at Marcum.

Taxpayers may also want to start buying digital currencies in a self-directed Individual Retirement Account. Any trading of the currencies within the account wouldn't be subject to capital gains tax — taxes would just be triggered when the money is withdrawn. Beware of the fees though, which are typically higher than a traditional IRA.

As the end of 2021 draws near, remember an advantage that crypto owners have over stock investors: cryptocurrency doesn't have a wash/sale rule, which bars stock investors from taking a deduction for a loss if they repurchase the same security within 30 days. That means a crypto owner can sell unrealized losses by Dec. 31, 2021, to offset some gains, and then buy the crypto back in early 2022.

And here's what not to do: use current crypto holdings as collateral to acquire a new crypto asset. Some investors do this in part because it avoids triggering capital gains tax, since they aren't selling or exchanging anything. But it's a dangerous tactic because it's banking on no market downturn. Crypto markets are way too volatile to make that a good bet.

Alexis Leondis is a Bloomberg Opinion columnist covering personal finance. Previously, she wrote about personal finance, asset management and mortgages, and oversaw tax coverage for Bloomberg News.