Planning With Cryptocurrency – Part III Minimizing the Tax Effect of Cryptocurrency Transactions

Planning with cryptocurrency continued…  In my previous article, I covered how cryptocurrency is taxed and hard and soft forks.  This article addresses different strategies for minimizing the tax effects of selling cryptocurrency.

I will cover the following topics in subsequent articles:

• What happens if I contribute cryptocurrency to a partnership or corporation? What should I look out for?
• If I want to donate cryptocurrency, what are the appropriate steps, and what should I look out for?
• How do I protect my cryptocurrency from being stolen?
• What is the best way to incorporate these alternative assets within my estate planning?
• What do I need to tell my CPA and my estate attorney regarding where I hold them?

Most of our high net worth families have the luxury of a buy and hold strategy.  They believe the price of their cryptocurrency will go up substantially in the long run.    Some of them may deploy an additional strategy of Crypto Staking.  This strategy generates a revenue stream from the cryptocurrency they hold without selling it and incurring a substantial gain.  Think of this type of strategy as lending money to someone and earning interest on the money you lend.  Although this type of strategy will generate ordinary taxable income resulting in a better return on investment (ROI), we advise them to apply rigorous safety and security procedures to minimize the possibility of fraud.  Please read my upcoming article on how to protect your cryptocurrency from being stolen to address these issues in the series.

So, you have decided to sell your cryptocurrency.  Like most of our clients, you may want to know how to defer or minimize the tax on the sale.    Here are some strategies to use to accomplish this objective:

Using Tax Deferred Accounts to Buy Cryptocurrency

You can purchase cryptocurrency in your self-directed IRA or Roth IRA accounts.   Since cryptocurrency is not considered a prohibited IRA asset by the Congress or the IRS, you can have your IRA invest in cryptocurrency.   Thus, if you sell it at a substantial gain, it will grow tax free.

It is important to find an institution that allows you to set up a self-directed IRA.

Be aware that your IRA cannot transact business with yourself, or a related party nor can you benefit personally from the cryptocurrency asset that your IRA purchases.  If you participate in transactions with your IRA or related parties, you may jeopardize the tax free status of your IRA and incur taxes and penalties.   Its best to consult with a professional before making these types of IRA investments.

Control the Amount of Capital Gain or Ordinary income that You Recognize!

As a wise one once said, timing is everything.  When you look back at the major economic shifts which have created economic opportunity and resulted in major wealth creation, it was the individuals who were aware of these shifts, had luck on their side and controlled the timing of their liquidity event that were able to create the most wealth.   You can achieve the same result when you control the timing of your sale in cryptocurrency.

• When controlling the timing of your cryptocurrency sale you may consider:
  • Economic landscape and not just the tax implications of buying and selling.
  • Taking into consideration whether you may incur a substantial ordinary or capital loss on other property which may offset your selling gains.
• Accelerate recognizing gains in years:
  • Where you do not have much income or
  • You have substantial capital loss carryforwards.
• In years where you have substantial ordinary income or capital gains you may want to:
  • Postpone recognizing gain (if economically prudent) or recognize gain to the extent of anticipated net capital loss carryforwards.

Use the Installment Method for Selling Your Cryptocurrency

The IRS considers cryptocurrency as property.   As such, you may qualify for reporting the gain (not loss) on the sale of your cryptocurrency over a period of years.  If you are receiving at least one payment in a different year than the year you sell your cryptocurrency, you may qualify for installment gain reporting.

If you decide to sell near the end of the year, consider taking one payment close to the end of the year and the next one near the beginning of the next year.  As always, make sure that you know your buyer and their ability to pay before entering this type of transactions.

Control the Cryptocurrency that You Sell by Using the Specific Identification Method

In your cryptocurrency portfolio, you may have different cryptocurrency types, purchase dates and costs.   In a typical cryptocurrency portfolio for our clients, the cryptocurrency that they purchased first, frequently has the lowest cost basis and the longest holding period.

If you do not specifically identify the cryptocurrency you are selling, the IRS requires you use the cryptocurrency you have held in your portfolio for the longest amount of time.   This method of identifying the cryptocurrency you sell is called the First in First Out (FIFO) method.

The IRS does not allow the use of average cost basis for selling your cryptocurrency.  This method is mostly used to value the cost basis when selling your mutual funds.  It is calculated by dividing the total amount of dollars invested in a mutual fund position by the number of shares owned, to determine the cost basis of the shares that you have sold.

Fortunately for taxpayers, there is another method of identifying the cryptocurrency you sell.  You can pick and choose the specific cryptocurrency purchase date or cost basis you would like to sell.   This method of identifying the cryptocurrency to be sold is called the Specific Identification Method.  In most cases, the Specific Identification method will produce the best tax results.

To use the specific identification method, identify the cryptocurrency you are selling by:

• Documenting the unit’s unique digital identifier such as a private key, public key, an address, or records showing the transaction information for all units of a specific virtual currency held in a single account, wallet, or address. Your transaction information must show:
  • The date and time each unit was acquired.
  • Your basis and the fair market value of each unit at the time it was acquired.
  • The date and time each unit was sold, exchanged, or otherwise disposed of and
  • The fair market value of each unit when sold, exchanged, or disposed of, and the amount of money or the value of property received for each unit.

If you have a considerable amount of cryptocurrency, we recommend you use a software program to track your cryptocurrency transactions.

Consider if Your Trading Activities Can Elevate You to Trader Status

Unlike investors in cryptocurrency, who are only able to recognize short-term or long term gains and losses when they sell their cryptocurrency and are not able to deduct any expenses associated with their investment trading, traders can deduct the expenses from their trading activities.

To achieve trader status, you must trade substantially and regularly, and continuously profit from short term price swings.  Additionally, your trading activity must produce a majority of short-term rather than long-term gains and losses.

Like investors, you will not be subject to self-employment tax, but your income will be subject to the additional 3.8% investment income tax.

As of April 2021, unlike stock and commodity day traders, cryptocurrency day traders are unable to use the mark to mark accounting election.   This election, if available, would convert capital gains and losses to ordinary gains and losses.  If cryptocurrency becomes classified as a security or commodity in the future, cryptocurrency day traders may take advantage of this election.

Restructuring Your Family Office to Deduct Family Office and Cryptocurrency Expenses

Restructuring your family office may allow you to deduct your family office and cryptocurrency expenses.   Although the method of restructuring is beyond the scope of this article, please feel free to contact us if you are considering this as a tax strategy.

Acting as lifestyle advisors is the primary focus for our high net worth families.  By assisting them in preserving their wealth, and effectively transferring that wealth to the next generation, we educate the family and their children on how to achieve their family objectives.    If their objective is achieving social development goals through impact investing, we can recommend and monitor their wealth advisors.

Let us know how we can assist you and your family.

My next article will address the benefits and pitfalls of contributing cryptocurrency to partnerships and corporations.   If you enjoyed or found this, or any of my articles helpful, please feel free to share them with your friends and colleagues.

We hope you found this article about Planning with cryptocurrency helpful.  If you have questions or need expert tax or family office advice that’s refreshingly objective (we never sell investments), please contact us or visit our Family office page  or our website at www.GROCO.com.  Unfortunately, we no longer give advice to other tax professionals gratis.

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Considerately yours,

GROCO, GROCO Tax, GROCO Technology, GROCO Advisory Services, GROCO Consulting Services, GROCO Relationship Services, GROCO Consulting/Advisory Services, GROCO Family Office Wealth, and GROCO Family Office Services.