Cryptocurrencies were initially envisioned as a tool to facilitate the exchange of goods and services. They are meant to be a digital alternative to hard cash, allowing people to trade securely both online and in conventional stores.
However, they have been used as a channel of investment by a good number of Americans who have enjoyed healthy returns after buying tokens for speculation. Some people have profited by joining block chaining projects early while others are making a decent passive income by mining cryptocurrencies.
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As with any other venture, gains from cryptocurrency investments need to be reported so that the appropriate tax can be applied. If you file your taxes right, you can end up with a lower tax liability. You can appease the IRS while spending less of your hard-earned gains.
1. Gather All Transactions and Income
An important first step to putting a lid on your cryptocurrency tax is to begin keeping meticulous records of all your cryptocurrency transactions. The IRS requires cryptocurrency miners who are formally employed to declare any gains from this activity as part of their gross income. But this income must be in its dollar equivalent in value. For this conversion you will need to use the value of the dollar as at the time you were receiving the income.
If you’re self employed, it should be included on the form as part of the gross taxable income subject to self-employment tax. Last year the IRS sent out letters warning crypto traders and investors against underreporting their transactions. This is why you would take this record-keeping seriously. The communication came with advice to amend their returns or face possible penalties.
To harmonize the recording of cryptocurrency transactions, the IRS came up with guidelines for doing so. A recorded transaction must include the date and time when the cryptocurrency was purchased as well as the fair market value of the unit at the time of purchase. For every sale you also need to indicate the date and time of the transaction as well as the fair market value of the unit at the moment of sale.
Having this information will not only help you appease the IRS, it will help you lower capital gains tax on your cryptocurrencies significantly. Using tax calculation methods such as Last in First Out (LIFO), or Highest In, First Out (HIFO), you can reduce your gains, which in turn beans you will pay less in gains tax.
2. Calculate Capital Gains and Losses
Cryptocurrency is looked at as an asset in the eyes of the IRS. Therefore, if you made any money off that asset during the year, it should be subject to capital gains tax. On the other hand, if the asset depreciated in value and you made a loss, you shouldn’t be liable to the IRS. In theory, determining this should be a simple calculation if you’ve been keeping coherent records of your transactions:
Fair market value – Cost basis = Capital gains/losses
However, in recent times, the IRS has reworked its guidelines to factor in events like hard forks and airdrops, which, though rare, affect the value of the cryptocurrency.
Calculating cryptocurrency tax has been made easier by the advent of software that does precisely this. You can record transactions on it as they happen or import your trade history onto the platform in bulk and apply the previously mentioned methods to ensure your gains work out to be minimal.
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After that you can download a complete IRS form ready for your accountant, or upload to an online tax program. A number of these automated calculators can seek out loss-making transactions in your history to lower your dues.
3. Watch Holding Periods
The IRS is generally happier when you hold on to assets for longer and it will be of benefit to you to hold on to your cryptocurrency for more than a year. If you do so you will be put in the long-term capital gains tax category instead of the short-term one. The former attracts higher interest rates.
This strategy works even better when you identify your cryptocurrencies individually. Proving that you have held the units for more than a year further brings home the importance of recording all your cryptocurrency transactions.
Avoid the IRS
It is important to report your cryptocurrency transactions and file your returns to avoid incurring the wrath of the IRS. But even as you do so and pay the cryptocurrency taxes due, use these easy tricks and tips to minimize their impact on your margin. And you can take advantage of available technologies to help you with everything from recording your transactions to seeking out ways to minimize your capital gains.