Help your clients keep more money: 5 crypto tax strategies

In 1966, the Beatles released the hit song “Taxman” to protest the higher level of progressive tax imposed in the United Kingdom.

Fast forward to 2022. With the emergence of cryptocurrencies and the hundreds of ways investors, traders, and businesses generate profits from activities within the cryptocurrency ecosystem, the conversation around taxable events in this digital era is under intensive review.

A basic overview of crypto taxes

In the United States, the IRS continues to classify virtual currency transactions as taxable by law, just like transactions in any other property or security, such as real estate and stocks.

The recent crypto tax reporting rules in the 2021 Infrastructure Investment and Jobs Act (IIJA) further clarifies that digital assets, such as virtual currencies, will be treated like securities in terms of capital gains and losses. This makes the tax treatment of digital assets unchanged; you would continue to pay taxes on capital gains.

For example, if the cryptocurrency’s value appreciates, and you trade, exchange, sell, and/or use it for profit, the gains are taxed at the capital gains rate. Naturally, if the asset depreciates in value, you may have the opportunity to deduct the losses from other capital gains and potentially reduce your taxes. To properly identify capital gains and loss, and whether the transaction falls under short-term vs long-term rates, it’s important to keep track of each transaction’s date, purchase price, sale value, and fees.

The most common taxable events in crypto are:

• Selling, swapping, or exchanging crypto to fiat currency (this activity could generate a capital gain or loss).
• Earning crypto as income, including mining, hard forks, and airdrops.
• Spending crypto to purchase goods or services.
• Exchanging one cryptocurrency for another cryptocurrency.

Based on these common taxable events, most crypto transactions are taxable.

There are a few exceptions:

• Using your fiat currency to buy cryptocurrencies (similar to how you use fiat to buy stocks, bonds, and commodities).
• Donating cryptocurrency to a tax-exempt organization, based on charitable donation rules.
• Gifting cryptocurrency to anyone, assuming it falls under gift tax rules.
• Transferring cryptocurrency from one wallet you own to another wallet you own, similar to transferring money from your checking account to your savings account.

The IRS has provided answers to the most frequently asked questions regarding the tax treatment of cryptocurrencies in the Frequently Asked Questions on Virtual Currency Transactions guide. As the IRS and the SEC establish further regulations and guidelines around the activities of the cryptocurrency, proper recordkeeping can help your clients plan a tax efficient strategy, similar to tax-loss harvesting methods used to minimize tax obligations for stocks.

5 tax strategies to treat cryptocurrency

1. Wash Sale Rule is exempt (for now)

A current tax loophole available to cryptocurrency users is the lack of the wash sale rule.

Here’s how it works: Let’s say you purchase $20,000 worth of Bitcoin. During this time, the market turns bearish and decreases the value to $10,000. Your Bitcoin is now worth $10,000 and your unrealized capital loss is $10,000. Since the wash rule doesn’t apply to cryptocurrencies, as of now, you could sell your Bitcoin to capture a capital loss of $10,000, and since you don’t have to wait 30 days before repurchasing, you can promptly repurchase Bitcoin.

In this scenario, you would lock in a capital loss to offset other capital gains and continue to own the cryptocurrency. However, this is a short-term solution, as Bitcoin may be sold in the future to capture profits and therefore trigger a taxable event … not to mention regulators who are considering closing this loophole. As a result, this is, at best, a short-term remedy.

2. Consider trading crypto inside a Roth IRA

Many crypto-friendly Roth IRAs, such as Alto, allow Bitcoin to be traded inside this tax-favored vehicle. Similarly, some crypto-friendly IRAs allow for trading alternative coins such as Ethereum. Others limit you to Bitcoin only.

The drawback to a Roth IRA is that the maximum contribution limit, $6,000 as of 2021, doesn’t allow for a substantial capital investment.

3. Research the pros and cons of a crypto Loan

In the eyes of the IRS, personal loans are not considered income, with the exception that the loan is cancelled or forgiven, which is then considered a cancellation of debt income.

For crypto loans, most apps such as Celsius and Nexo offer loans starting at 0% APR. However, they limit the maximum loan-to-value (LTV). Unlike traditional loans that rely on your credit score, crypto loans rely on collateral to secure the loan. This means they are tax efficient, there are no origination fees, no credit check, little to no monthly installments, lower interest rates, near instant approval, and you can use the proceeds as you see fit.

The downside is the risk of liquidation and margin calls. Currently, many crypto apps limit the maximum LTV to 50%. 

Let’s say you use $5,000 worth of Bitcoin as collateral to take out a $2,500 loan (50% LTV). A week later, Bitcoin’s price falls and your LTV ratio jumps to 65%. You would expect a margin call to be triggered. Depending on the app, you’ll be given a tight deadline to deposit enough collateral to return your account to 50% LTV or lower.

Now, if Bitcoin experiences a massive price drop and your LTV skyrockets to 80% or more, some or all of your assets inside the app can be sold or liquidated to repay the loan. If you find yourself in the unfortunate event of a liquidation, you may be eligible to claim it as capital loss.

Most apps prefer to avoid liquidation as much as possible, and provide you with options to avoid this last-resort scenario.

Bottom line: Do your due diligence to understand the liquidation and margin call terms the loan is subject to, and keep in mind that if you use the loan proceeds to buy and sell more cryptocurrencies, the normal treatment of crypto taxable events applies. 

4. Consider seeking trader tax status or form a corporation

According to the IRS Topic 429, there are some tax-efficient benefits to qualifying for trader tax status. Since cryptocurrencies are viewed as a security, according to the IIJA, this status has captured the attention of many crypto traders.

The advantages of trader tax status include writing off losses, deducting business-related expenses, such as any sole proprietor, self-employment tax exemption, and employee benefit deductions. However, there are vague conditions that leave open a wide door for interpretation, and when you add cryptocurrency to the topic, the waters get murkier.

Special rules apply if you’re a trader in securities, or in the business of buying and selling securities for your own account. The law considers this to be a business, even though a trader doesn’t maintain an inventory and doesn’t have customers. To be engaged in business as a trader in securities, you must meet all of the following three conditions:

1. You must seek to profit from daily market movements in the prices of securities, and not from dividends, interest, or capital appreciation.
2. Your activity must be substantial.
3. You must carry on the activity with continuity and regularity.

The following facts and circumstances should be considered in determining if your activity is a securities trading business:

• Typical holding periods for securities bought and sold.
• The frequency and dollar amount of your trades during the year.
• The extent to which you pursue the activity to produce income for a livelihood.
• The amount of time you devote to the activity.

If the nature of your trading activities doesn’t qualify as a business, you’re considered an investor instead of a trader. It doesn’t matter whether you call yourself a trader or a day trader; you’re an investor. A taxpayer may be a trader in some securities and may hold other securities for investment. The special rules for traders don’t apply to those securities held for investment. A trader must keep detailed records to distinguish the securities held for investment from the securities in the trading business. The securities held for investment must be identified as such in the trader’s records on the day they acquire them, for example, by holding them in a separate brokerage account.

From my conversations with accountants, if you generate income from another business or job, qualifying for this desirable status may be difficult.

Another alternative is to consider creating a separate corporate entity through which you will conduct your trading activities, enabling you to receive the comparable tax treatment as a qualified trader without having to formally qualify.

If it makes sense for your accounting practice, consider developing a “Done For You Crypto Corporation” service, where you help your clients set up the entity to trade through. Research the possibilities to make their lives easier and their trading more tax efficient. 

5. Research Private Placement Life Insurance (PPLI)

This is an intriguing topic worth further research and usually suited for high-net-worth clients, because the set up and administrative management fees can be cost prohibitive to the average crypto trader or investor.

The good news is the tax saving potential of PPLI is too sweet to ignore for several reasons:

• The insured person doesn’t pay taxes on investment gains. 
• Beneficiaries may avoid taxes when the death benefit is paid.
• When properly structured, the insured person’s estate may not be required to pay taxes.
• There are no taxes on phantom income.
• The insured can generally access most of the funds, tax-free, through policy withdrawals and loans.
• There is asset protection from creditors.
• There is easier tax compliance.

However, the sobering news is that your due diligence will reveal PPLIs are an unregistered securities product, meaning agents can only present them to accredited investors. In addition, the insurer must possess the ability to fund $1 million or more in annual premiums for several years. It’s no wonder that wealthy families, trusts, and corporations collaborate with financial firms to reduce their tax burden. Do your research, as some of your crypto clients may qualify to take advantage of this top-tier wealth preservation strategy.

Track the tax

Regardless of the tax strategy, the largest hurdle to cross is tracking the countless transactions made through wallets and exchanges. 

Crypto tax tracking software such as CoinTracker can help your clients see in real time their capital gains or losses, and encourage them to have an open conversation with you about tax-efficient strategies. Before any strategy can be created, it’s imperative to have software keep track, as it’s near impossible to manually capture all the data required to analyze capital gains or losses, especially for crypto traders involved in hundreds to thousands of transactions per month.

Be an ally to your crypto clients by holding them accountable to track their transactions, and they’ll hold you accountable to help them implement strategies to minimize their tax liabilities. As the saying goes, it’s not how much you make; it’s how much you get to keep that counts. The accountants and tax strategists who nail this topic will be in high demand for the bright future ahead.

Disclaimer: Seek advice and guidance from experienced and credentialed financial professionals for further guidance. This content is for educational purposes only and is not used as legal, tax, or financial advice of any kind.