Part I of this blog post offered background on cryptocurrencies, including the different types, how to value them, and how they generally are taxed at the individual level. This post will discuss more specific strategies related to types of taxation, strategies to minimize tax and how to keep your cryptocurrencies secure.
Read “The Intersection of Cryptocurrencies and Individual Taxation – Part I”
How Will You Be Taxed if You Profit from Cryptocurrency?
Investing / Investor Tax Status
For the majority of individual retail investors, the most common strategy to earn a profit on cryptocurrencies is to buy and hold a select few of them or an entire portfolio. The strategy is simple, make an initial investment and hold the assets indefinitely or until a certain valuation is achieved. Since cryptocurrencies are a relatively young asset class, the thought is that the assets will mature with time and become significantly more valuable (think dotcom era in the 1990s). Alternatively, more tech savvy individuals may try to take advantage of short-term or mid-term swings in market valuation to further increase potential gains, ideally buying low and selling high.
Depending on the number of trades entered into by an individual during the taxable year, the individual should be considered an “investor” for income tax purposes. This treatment means that the individual is not an “active trader” and any realized gains (or losses) would be classified as capital. Additionally, if any expenses are incurred in the business of investing and not relating to the purchase or sale of the assets, they would be classified as portfolio expenses (previously subject to 2% of AGI limitation) and would be non-deductible to the individual. Also, any interest expense incurred that are related to the investments would be limited to the individual’s total net investment income and deductible on Schedule A as an itemized deduction.
Trading / Active Trader Tax Status
Another common strategy that some individual retail investors engage in is actively managing their portfolio of cryptocurrencies, sometimes making over 100 trades in a single day. The goal is to capture daily, or sometimes hourly, fluctuations in the asset’s market value.
This strategy is difficult to execute and requires consistent attention and generally the use of automation to capture the valuation swings in the moment. Given that cryptocurrencies are traded 24/7/365, assets are typically liquidated and exchanged back to “fiat” at the end of the trading session. However, given the extreme volatility of the cryptocurrency asset class and the significantly lower trading fees, actively trading cryptocurrencies could be considered relatively more favorable than traditional assets, such as equities, futures, etc.
This type of investment strategy generally causes the individual to be considered an “active trader” for income tax purposes. A trader is treated different from an investor for income tax purposes. First, the expenses incurred in the business of trading would be fully deductible as an ordinary expense (ignoring other limitations at the individual level). Additionally, certain elections may be made that could affect the classification of the income or loss as capital or ordinary. Unfortunately, as of the drafting of this article, the IRS has provided little guidance on the property classification of cryptocurrencies, and it is not currently clear which of the possible elections are available. Any interest expense incurred in the business of trading should be considered business interest and fully deductible (again, ignoring other limitations beyond the scope of this discussion).
Mining / Profits Deemed Ordinary Income
Individuals may also obtain cryptocurrency through an activity known as mining. Mining typically involves providing computing power to help with the process of cryptography, which lends toward authenticating transactions made on the blockchain. Once a block is mined, the miner is then rewarded with newly issued coins. As of the date of this post, the current block reward for bitcoin is 6.25 BTC.
There are a few different ways to go about mining cryptocurrencies. The most direct method is to create the computing power and mine the blocks directly. This requires a massive amount of computing power, often more than the casual miner is able to create or afford. The casual miner will often participate in a mining pool, where they are part of a large pool of miners who all lend a small amount of computing power to collectively mine blocks. Once a block is mined, the reward is then disbursed proportionately to the individuals in the pool. If the individual does not want to provide their own hardware or lacks sufficient hardware, they could participate in cloud mining, where they rent or lease computing power from an offsite location and then participate in a mining pool.
Pursuant to current IRS guidance, regardless of the method used to mine cryptocurrency, the tax treatment is the same. The reward is valued at the date received and is considered to be income. The amount of income recognized is then the owner’s basis in the coins received. Given the nature of the activity, the income is ordinary and subject to self-employment taxes. Any and all expenses incurred in the activity may be deductible, including energy costs for using your own mining rig or the rent or lease fee paid for cloud mining. Taxpayers must capitalize and depreciate any assets acquired and used in the activity. In the event the taxpayer is mining as a hobby, the expenses would only be deductible to the extent of income.
Staking / Profits Deemed Ordinary Income
Another method of obtaining cryptocurrency is through an activity known as staking. Staking is similar to mining in that it lends toward validating transactions on the blockchain; however, the approach is very different. To stake, an individual need only purchase a cryptocurrency used in Proof of Stake, “PoS,” and hold the cryptocurrency in a specific wallet for a period of time. The owner is then rewarded for staking their cryptocurrency with a portion of the transaction fees collected. The longer an individual stakes their cryptocurrency, the more they could earn.
Absent guidance from the IRS, cryptocurrency earned through staking may also be considered income and is valued as of the date received. Depending the level of staking, the income should be ordinary and may be passive in nature.
What Strategies Can Minimize or Defer Tax on Cryptocurrency Gains?
As with any thorough discussion on any tax related subject, the inevitable question is: How can I minimize the related tax burden? Minimizing taxes on cryptocurrency gains requires careful tax planning. The first step is deciding which lot relief method to use, be it FIFO, LIFO, specific identification or other reasonable method. The IRS is currently allowing any reasonable lot relief method as long as certain requirements are met regarding identification. The key is to remain consistent, regardless of the choice.
During the 2017 bubble, the most common method was LIFO, as the last lot purchased typically had the highest basis. Unfortunately, during the 2018 bear market, those that used LIFO in 2017 had very little basis remaining and were required to recognize large gains while their portfolio value decreased. Those that began investing in 2018 were better served using the FIFO method, as this would have typically maximized losses. Specific identification is arguably the best method to use, as the investor could choose to relieve any lot that would benefit them the most. However, specific identification requires complete and thorough record keeping, which could be cumbersome depending on the investment strategy.
Another method to reduce tax liability relating to cryptocurrencies is to harvest losses. This requires identifying lots that are in a loss position and selling them to realize the losses. Unlike traditional investments, cryptocurrencies have not been identified as securities and therefore may not subject to the wash sale rules. Once a loss is recognized, the same position could be immediately bought back, if desired. This strategy does carry some risk, as harvesting the loss also resets the holding period if bought back and a position that might otherwise carry a small long-term gain may need to be later realized at a larger short-term gain if not held long-term from the repurchase date. Also, given the IRS’ lack of guidance, they could later classify some or all cryptocurrencies as securities, retroactively challenging losses and reclassifying them as wash sales.
Alternatively, cryptocurrency or any other capital gains could be deferred by investing in a Qualified Opportunity Zone (QO Zone) or QO Zone fund. In short, reinvesting capital gains within 180 days of recognition can be deferred for a period of up to 10 years and a portion of the gain could be forgiven.
Read “10 Key Questions – Answered – About Qualified Opportunity Zones”
What Should You Do If You are a Victim of a Security Breach?
Lastly, a prominent and potentially disastrous issue the cryptocurrency world is facing right now is security breaches. Due to its nature, the blockchain is nearly, if not completely, impossible to hack. Therefore, bad actors need a different method of stealing cryptocurrencies. The most news worthy security breaches are occurring at cryptocurrency exchanges, where coins are held on the exchange. Hackers infiltrate the exchanges and steal any coins held in a “hot wallet.” A hot wallet is a storage wallet that is held electronically and is constantly or frequently connected to the internet. Best practices would be to only hold coins on exchanges when actively trading them. Once trading is completed, it’s best to transfer any coins off the exchange and into a form of “cold storage.” There are other methods for stealing coins, but they predominately involve hacking someone who is not diligent with their security protocols.
In the unfortunate event coins are stolen and are not recoverable, a taxpayer could have significant losses. This may be considered a casualty loss of personal property deductible in years prior to 2018. However, the Tax Cuts and Jobs Act suspended the deduction (except for qualified disasters) through 2025. Until then, the loss of coins due to a breach or other type of fraud or loss is non-deductible.
While there are numerous way to profit from cryptocurrencies, it’s just as easy to generate losses. Fortunately, the tax code provides many methods for making your gains as tax-efficient as possible.
Please contact a member of your service team, or contact Matt Rager at email@example.com for further discussion.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.