Cryptocurrency has become an inviting prospect for most investors. However, as the government catches up with the technology, taxes are not far behind. To help you maximize your profit and accelerate wealth-building, here are six legal strategies for avoiding capital gains tax on your crypto investment. Don’t forget to check out our Ultimate Guide to Reduce Taxes on Cryptocurrencies.
1. Use Your Self-Directed IRA
An individual retirement account refers to a savings account that helps citizens save up for their retirement funds. What most people don’t know, however, is that it offers a lot of tax advantages. Your IRA allows you to invest in traditional investment options like mutual funds, stocks, or even exchange-traded funds (ETF).
However, there is a specific type of IRA, the self-directed IRA, that allows you to invest in non-traditional assets like precious metals, real estate, and crypto-assets. Following the applicable regulations and procedures, you can set up a self-directed IRA where you can buy cryptocurrency assets.
Generally, an IRA gives you the option to make tax-deductible contributions during your working years. However, once you retire, your withdrawals become subject to the usual taxes. This mechanism means that as you purchase crypto from your IRA, all capital gains tax from the sale of these assets will be deferred until you start taking distributions.
2. Pay Less Capital Gains Taxes With Tax-Loss Harvesting
Tax-loss harvesting refers to the practice of selling stakes, interests, or securities at a loss. This loss is used to offset the capital gains tax made from the sale of other stakes, interests, or securities at a profit.
Note that whenever you sell an investment, you either gain or lose profit. Technically, it starts with those of the same type offsetting each other. For example, short-term capital gains cancel out short-term losses, and the same for long-term capital gains and losses. It helps people recover quickly from any investment losses they might suffer along the way.
The same system applies to cryptocurrency. Cryptocurrency investments that have already lost value can be sold to realize that loss and use it to offset pending capital gains tax. Imagine you have $10,000 in capital gains from the increasing value of Bitcoin (BTC). On the other hand, you have an Ethereum (ETH) that has decreased by about $5,000 in value.
By not selling, you will shoulder the capital gains tax from your $10,000 growth in BTC investment. However, by selling the ETH at its current value, you realize the $5,000 loss it has suffered. You can then use this loss to offset your supposed tax, leaving you with a tax liability of $5,000 in capital gains.
Tax-loss harvesting also works with other assets such as stocks and real estate. Using it in your crypto assets ensures that you can recoup your losses by offsetting them with gains from other investments.
3. Donate to Charity with CRTs
The tax code sets aside a number of systems to incentivize sharing your wealth with the needy. A charitable remainder trust (CRT) is an irrevocable trust that lets you reduce your taxable income and defer tax on capital gains for valid assets—cryptocurrency investment included.
Essentially, a CRT is a split-interest vehicle that generates two income streams for the investor. First is that it pays a regular income to the donor or the beneficiaries, whoever is named in the trust, for a set period of time or an entire lifetime. After the set period for the CRT has lapsed, the remaining assets and value in the trust are transferred into a charitable institution of your choice.
By donating assets into the trust, you can start enjoying its tax deduction benefits. Tax deduction depends on a number of factors: the specifics of the CRT, the projected income payments, and the interest rates from the IRS. Taxes for short-term capital gains are deferred for the duration of the trust.
Take note that once you’ve donated your crypto assets to a CRT, consider it gone forever since the trust fund is irrevocable. It will, however, continue to generate income for you and the beneficiaries named.
4. Buy Crypto Through An International Life Insurance Plan
Another strategy for paying zero capital gains tax on your crypto sales is through investments made in an international life insurance plan. This plan is similar to a traditional IRA, but lets you fund an Offshore Private Placement Life Insurance with almost no restrictions on contribution or distribution terms.
A recommended approach for this one is to set up a private placement policy. You leave it alone for a few years. Then, if you close it down, you get the updated amount of the policy plus a tax deferral equivalent to a traditional IRA. Remember that you’ll still be liable for a percentage of the gains tax when you close down the policy.
Furthermore, by holding the policy until your death and passing the cryptocurrency assets to the heirs, they receive it tax-free. Through the change in policy basis, the heirs receive the virtual assets at their price on the date of your passing. This leaves them free from taxes incurred from the appreciation of the cryptocurrency for the entire period they were stashed in your international life insurance policy.
5. Be a Puerto Rican Resident
This sounds like a weird suggestion, but Puerto Rico is actually an unincorporated territory. Despite being located in the middle of the Caribbean, residents on the island are also subject to certain federal laws, but not all of them.
Citizens are required to pay taxes wherever they are in the world. However, this rule doesn’t apply to the people of Puerto Rico. Specifically, the Internal Revenue Code Section 933 explicitly takes note of this, particularly those that qualify for Act 20 or Act 22. In short, residents of Puerto Rico are not subject to federal taxation and have their own laws on imposing taxes. A separate tax bill also applies for cryptocurrency taxes owed by its citizens.
Any citizen who spends at least 183 days on the island can be considered a resident. If you move your cryptocurrency holdings to an entity based on the island and qualify for Act 22, then you’re exempted from crypto taxes on short- and long-term capital gains. Btw, we have a whole article devoted to everything you need to know about Puerto Rico and crypto taxes.
6. Declare Your Crypto Earnings as Income
By receiving crypto coins in exchange for goods or services, or if you mine cryptocurrency from your own rigs, then it can be considered as a part of your income. Under this condition, taxes work slightly differently.
As an income, you will be legally required to report the fair market value of the virtual coins at the moment you received them when you pay taxes. It is then subjected to the usual income tax rates, which are reported together with your other forms of income.
However, when you eventually let go of the cryptocurrency declared as income, you will need to pay capital gains taxes. The basis, or the fair market value of the crypto when you received them, will also be the basis for computing the capital gain. This only applies to capital gain on cryptocurrency that is disposed of, sold, or traded.
If you also mine your own crypto coins, remember that the government considers cryptocurrency mining as a self-employment endeavor. This means that you’ll also be liable for self-employment taxes on top of the applicable ordinary income taxes.