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How to Navigate Taxes on Cryptocurrencies

Unraveling the complexities of crypto taxes

Navigating the regulatory landscape in cryptocurrency can be challenging. Governments worldwide are grappling with how to tax and regulate this emerging asset class. Understanding the evolving regulatory environment is the first step in managing your crypto tax obligations. Even though the U.S. defines cryptocurrencies as property, for example, it’s most akin to the taxation of securities and many activities like trading on exchanges look just like trading securities. However, the U.S. regulations don’t specifically define “digital assets” and securities-related taxation that may otherwise apply can’t be applied without changes to the laws. These definitional changes have happened in the U.S. with the passage of the Infrastructure Act.

Understanding crypto tax rates

Cryptocurrency tax rates vary globally, ranging from capital gains taxes to income taxes. 

The tax rates on cryptocurrencies are influenced by several factors, and they can vary significantly based on the jurisdiction and the nature of the cryptocurrency transaction. Some tax rates are obviously higher than others so the goal is to shift tax to a lower tax rate bucket when possible. Having a good working knowledge is huge for your crypto strategy because some things can’t be changed after the fact. For example, if you sell crypto one day before qualifying for a long-term period it could double your tax rate.

Here are some key factors that influence tax rates on cryptocurrencies:

Jurisdiction

Tax regulations for cryptocurrencies vary from one country to another. Some countries have embraced digital currencies and provide clear guidelines, while others may have stringent or ambiguous regulations. Some countries have low to no tax on crypto gains while other countries have high tax rates and unfavorable treatment relative to similar types of income.  

Holding period

The duration for which you hold a cryptocurrency before selling or disposing of it can affect the tax rate. Many jurisdictions distinguish between short-term and long-term capital gains, with different tax rates applied based on the holding period. Long term could be 12 months or 24 months, for example, and the tax rate can be as low as 0%. The U.S. even has a 0% long-term tax rate for a small range of gains. The difference between long and short term can be 2X to 3X higher (or infinite if comparing a 0% rate), making holding period one of the key tax strategies. 

Tax classification

Cryptocurrencies are often classified differently for tax purposes. They may be considered as property, commodities, securities or even as currency in some jurisdictions. In conjunction with holding period, the classification or type of the income is another big factor because different types of income have different rates. However, tax type limitations are another income type factor that most people don’t consider. For example, in the U.S. capital losses are limited to $3,000 per year and can’t be carried back to prior years. In some cases, the losses with one type of income can’t be offset with another.

Key Takeaway

Managing total tax liability has lots of interrelated moving parts and non-crypto income and deductions can affect and determine the outcome of crypto-related income and vice versa. Effective crypto tax management requires you be savvy with your overall tax picture.

Income tax vs. capital gains tax

The type of income generated from cryptocurrency transactions can influence the tax rate. If the profits are treated as capital gains, the tax rate may be different from income generated through mining, staking, or other activities. 

Taxpayer's income bracket

In some jurisdictions, the taxpayer's overall income level can influence the tax rate on cryptocurrency gains. Higher-income individuals may be subject to higher tax rates on their crypto earnings and/or other earnings. Many countries have a graduated tax rate system which means the more you make, the more tax you pay. There are a series of tax brackets for certain income amounts like $0 to $15,000, for example, and so on. The tax brackets have increasingly higher rates. So, a high-income taxpayer may end up in every tax bracket thus having parts of their total income taxed at every tax rate. This explains why all income is inextricably combined as a whole and tax planning is challenging.

EXAMPLE

Bob got an airdrop of XYZ coin worth $16,500 and he wants to know how much tax he owes on the airdrop. The answer is another question: What is your marginal tax rate? Meaning, what is your current highest tax bracket based on all your other income.

Tax reporting method

The cost method basis used to calculate and report cryptocurrency gains can impact the tax rate. Different jurisdictions may allow for different methodologies, such as First-In-First-Out (FIFO), Last-In-First-Out (LIFO), or Highest-Price-First-Out (HPFO) which can affect the amount of taxable gains. Some crypto tax software has up to 15 different cost basis methods.

Key Takeaway

With everything else equal, a cost basis method is single biggest factor in determining the amount of your gains and losses. If Alice applies FIFO and HPFO to the same set of transactions her gains could be wildly different.