Tax season is upon us. While this time of the year can be stressful, it tends to be particularly difficult for those who have invested in cryptocurrency.
The reason tax reporting on crypto in the U.S. is challenging has to do with the fact that the Internal Revenue Service (IRS) and the U.S. government consider cryptocurrency to be property, not currency, which means that it is subject to capital gains tax just like stocks or real estate.
This differs considerably from other countries, which have more friendly crypto tax laws. For example, in places like Portugal and Germany, cryptocurrencies are not subject to capital gains tax if they are held for longer than one year.
While citizens in other countries might be able to enjoy more lucrative returns and more favorable tax laws, here in the U.S., Uncle Sam wants his cut. And that cut can be hefty, depending on how long you have held your cryptocurrency. To avoid giving Uncle Sam too much of your profits, there is one simple yet crucial thing you must do: Hold your cryptocurrency for more than one year.
Unlike other countries where this could mean no tax at all, by holding for more than a year, cryptocurrency investors can avoid the short-term capital gains tax. Compared to the long-term capital gains tax, which tops out at 20% and is applied to profits from crypto held longer than a year, the short-term rate can be as high as 37%, depending on the investor's income level.
Developing a tax-friendly investing strategy
In addition to avoiding short-term capital gains tax, holding cryptocurrency investments for the long term can also help individuals mitigate the risks associated with investing in a highly volatile asset class. In an ideal world, your goal should be to hold investments for at least five years.
This level of commitment requires investors to prioritize investing in cryptocurrencies that have a proven track record and provide true long-term value. Unfortunately, the bulk of cryptocurrencies out there today likely don't meet these criteria. While it is a hot topic and at times highly contested debate, the only ones that likely meet this standard today in my view are Bitcoin (BTC 4.07%) and Ethereum (ETH 3.14%).
By holding investments like Bitcoin and Ethereum for the long term, individuals can reduce their exposure to more risky digital assets and potentially benefit from long-term price growth. Furthermore, by taking this approach, investors can avoid short-term capital gains tax, significantly reduce their tax liability, and thereby potentially increase their overall returns.
Some wishful thinking
The ultimate hope is that the U.S. keeps pace with other countries when it comes to their viewpoint of crypto as currency and not property. Fortunately, as talks of regulation heat up, so are calls for more fair taxation laws.
For example, the proposed Cryptocurrency Tax Fairness Act would create a de minimis exemption for cryptocurrency transactions under $50, which would effectively eliminate taxes for smaller transactions.
In addition, the Infrastructure Investment and Jobs Act, which was passed in 2021, includes provisions that require cryptocurrency brokers to report certain transactions to the IRS. This was a crucial step in making it easier for individuals to accurately report cryptocurrency transactions on their tax returns and could help reduce the risk of noncompliance.
Inevitably, as cryptocurrencies become more mainstream, regulators are likely to take a closer look at how they classify them and the tax implications of these investments. This could lead to clearer guidance on how cryptocurrencies should be taxed and might even stimulate further adoption.
But for the time being, crypto in the U.S. is still viewed as property. As such, this means crypto investors need to plan accordingly and take into account how this will impact potential returns. To make sure you maximize any profits and minimize your risk, ensure that you are investing in only high-quality cryptocurrencies that you plan on holding for the long haul.
