Handling Tax Liabilities & Crypto Taxes
Apr 5, 2023
This Blog was written in partnership with ZenLedger.
How crypto taxes work
The IRS classifies cryptocurrencies and other "virtual currencies" as property. As a result, you must report any cryptocurrency you receive as "income" and pay "capital gains" on any increase in value upon sale. (And no, it's not worth the risk of hoping the IRS doesn't notice your crypto income or profits—you should always report them!).
The first section you should pay close attention to on your Form 1040 tax return is the virtual currency question at the top. While you can check "no" if you've merely owned virtual currencies, you must check "yes" if you have received or exchanged/sold virtual currencies during 2022. Inaccurately answering this question can lead to problems down the road.
Then, there are a few steps to calculate your crypto taxes:
Aggregate Transactions – The amount of tax you owe depends on your total capital gains. But, to compute your capital gains, you must have a chronological list of transactions across all your wallets and exchanges (if you use multiple).
Complete Form 8949 – You must report each cryptocurrency sale or exchange on IRS Form 8949, including the cost basis, sale price, and capital gain or loss. Then, you add the total to determine your overall capital gain or loss for the year.
Complete Form 1040 Schedule D – The final step is to carry over the overall capital gain or loss from Form 8949 onto Form 1040 Schedule D. Then, you can continue completing the rest of your taxes to see how much you owe or get back overall.
When completing Form 8949, you can use the default first-in, first-out (FIFO) cost basis method or match purchase and sale transactions using the specific identification method (e.g., LIFO or HIFO). For more information about these accounting methods, see our Tax Accounting Methods: How to Calculate LIFO And FIFO post.
Of course, if you receive cryptocurrency as compensation (e.g., mining), you must also report the income on Form 1040 Schedule 1 (for hobby income) or Schedule C (for business income).
How & when to file taxes
Several people complete their taxes with the help of a CPA or other tax professional. Alternatively, you can use online tax filing services like TurboTax if you have a relatively simple situation. Zenledger has tax professionals who can help with your crypto taxes, or, if you choose the latter option, ZenLedger provides a TurboTax integration that makes it easy to complete your crypto taxes accurately.
The deadline to file 2022 taxes without penalties is April 18, 2023. While an automatic six-month extension is available to anyone for free, you still have to pay taxes you owe by April 18 to avoid penalties. If you fail to file your taxes or request an automatic extension, the IRS charges a Failure to File Penalty equal to 5% of your unpaid tax every month (up to 25%).
You can file Form 4868 to request an automatic six-month extension if you need more time, but you must still make an estimated payment of at least 90% of your total tax or 100%/110% of your prior year tax liability (depending on your income levels) to avoid Failure to Pay Penalties.
If you fail to make an adequate payment, the IRS charges a monthly Failure to Pay Penalty equal to 0.5% of unpaid taxes, up to a maximum penalty of 25%. However, you can avoid paying these fees if you demonstrate reasonable cause, including paying at least 90% of your total tax due or 100%/110% of your prior year tax liability (depending on your income levels) by April 18 and the balance with your return.
Since the Failure to File Penalty is much greater than the Failure to Pay Penalty, it always makes sense to request an extension, even if you cannot afford to pay your taxes by April 18. And you can reduce your penalties by paying what you can afford by April 18.
The IRS does not charge any penalties if you are getting a refund.
What is the deadline for 2022 taxes?
The federal income tax deadline for the 2022 tax year is April 18, 2023. While the usual deadline is April 15, the extended deadline is due to Washington D.C.'s celebration of Emancipation Day.
State income tax deadlines for the 2022 tax year vary, so you must check with your state's tax authority or a tax professional to ensure you file on time. For example, Iowa's tax deadline is May 1, 2023, giving taxpayers a little extra time to file.
What happens if you miss the deadline?
Most taxpayers are eager to file their taxes and get their refund quickly. But, if you're entitled to a refund and miss the deadline, the only penalty will be a delay in receiving your refund.
If you owe money to IRS, you could face two penalties:
The "failure to file penalty" is typically 5% of the unpaid taxes per month or part of a month that the return is late, up to a maximum penalty of 25% of the due taxes.
The "failure to pay penalty" is usually 0.5% of the unpaid taxes per month or part of a monthly, up to a maximum of 25% of what you owe.
If you file your taxes on time, you can avoid the "failure to file penalty" even if you don't make any payments. So, it's always best to file something, even if you can't afford to pay your taxes.
What is the tax extension deadline for 2022?
You can file for an automatic extension by completing and submitting Form 4868. On the form, you must estimate your tax liability and disclose the payments you've already made. While you will still incur the "failure to pay penalty" if you don't make a payment before April 18, you can avoid the higher "failure to file penalty" with the extension.
The six-month tax extension gives you until October 16, 2023, to submit your final 2022 tax return.
If your estimated tax liability on your extension differs substantially from the actual tax liability you report on your tax return, you may be subject to penalties and interest on the unpaid tax. However, the IRS may be more lenient if your estimate is close to the actual amount owed (at least 90%) or if you can show reasonable cause for the difference.
Tax tips for 2022 and 2023
Don't Trust Your 1099-B – Some crypto exchanges send out 1099-B forms with your transactions and cost basis. While these figures will be accurate if you only use one exchange, you may have a very different cost basis after aggregating transactions. Exchanges and wallets cannot track digital assets cost basis once you transfer to a different wallet or exchange.
Max Out Your IRA – The IRA contribution deadline for 2022 is April 18, 2023, meaning you still have time to maximize your self-directed IRA contributions. These last-minute contributions can help reduce your overall tax bill or eliminate future capital gains taxes.
Harvest Tax Losses – Cryptocurrencies aren't subject to the Wash Sale Rule, making it easy to harvest your tax losses. For example, ZenLedger's tax loss harvesting tool can help you spot unrealized losses in your portfolio that you can realize to offset your taxes.
Be Careful with DeFi – Decentralized finance, or DeFi, transactions can be tricky. In fact, the IRS has yet to address some gray areas. So, it may be worth taking a conservative approach to hiring professional help for those engaging in these transactions.
Tax planning strategies for crypto traders & investors
Now that we’ve covered the basics, let's look at a handful of specific strategies you can use to cut down on your tax liability each year.
#1. Hold more than a year
Want to cut your tax bill by up to 12%? It's easy: Hold an asset for longer than a year before selling it. Doing so will generate long-term capital gains taxable at a lower rate than short-term capital gains.
Suppose you earn over $170,000, pushing you into the 32% tax bracket, and you decide to sell $10,000 in Bitcoin. If you've held the Bitcoin for less than one year and sold it, you will owe $3,200 in tax on the $10,000 gain. But if you sell after holding the Bitcoin for one year, the tax bill drops to $2,500—a $700 or seven percent savings.
#2. Harvest tax losses
Nobody wants to lose money on crypto investments. But if you do, be sure to harvest your tax losses. By selling a losing position, you can realize the loss and use it to offset other capital gains or up to $3,000 in ordinary income each year. And if you can't use it this year, you can carry the loss over into future years.
Even better, unlike the stock market, crypto assets don't fall under the so-called wash sale rule, which prevents you from immediately repurchasing the asset after realizing the loss. So, you can instantly replace the coins in your portfolio after realizing the loss. As a result, it makes sense to always look for opportunities to harvest losses throughout the year.
However, there’s no guarantee that tax loss harvesting will stick around forever. In fact, Biden’s new budget plan could close the crypto tax harvesting loophole if approved.
#3. Sell during low-income years
Your tax rate typically depends on your income. So, another way to reduce your tax burden is to sell during low-income years when your tax rate is lower—especially when it comes to short-term capital gains.
For instance, suppose it's December and you have an Ethereum position you've held for six months. If you plan to earn less next year (maybe you’re retiring or switching jobs), you might wait to sell until January 1st in order to realize a lower tax rate.
#4. Use an SDIRA
Most IRAs and other retirement accounts don't permit crypto assets. But a particular type of IRA, a self-directed IRA, or SDIRA, does. By holding crypto in an SDIRA, you can defer taxes until you sell or pay taxes immediately and avoid paying tax on any capital gains.
SDIRAs provide the same tax benefits as conventional IRAs but may cost more to set up and operate over time. So, talking with a tax professional is critical to determining if it's the right fit for your situation.
#5. Gift crypto to family
Many people financially support their children or other family members at some point. But gifting crypto rather than cash can help you lower your tax bill and provide the same support.
The IRS allows individuals to gift up to $15,000 per share, per recipient, without incurring any gift tax. Of course, there are a few rules. For example, you must still pay capital gains taxes if you gift crypto to children under 18 since the IRS views that as taxpayers trying to use a loophole. So consider speaking with a tax expert before using the strategy.
#6. Donate crypto to charity
Do you donate to charity? If so, donating your crypto assets instead of cash can help you realize a double tax break.
If you itemize your tax return, you can deduct your charitable contributions, and you will not owe any capital gains taxes on the appreciation of your donated assets. At the same time, the charity won't have to pay capital gains taxes, so it's a win-win for both parties.
#7. Move to a low-tax jurisdiction
Remote work has made moving more manageable than ever. And some moves can significantly reduce your tax burden, especially when it comes to crypto assets.
Alaska, Tennessee, Wyoming, New Hampshire, Florida, South Dakota, Texas, Nevada, and Washington have no state income tax. Depending on where you’re moving from, that could save you thousands of dollars annually. That said, states like New Hampshire still tax some interest, and other exceptions exist. So, it's essential to do your due diligence before packing up.
The bottom line
Tax season is stressful for everyone, but crypto assets can be an extra thorn in the side. Fortunately, crypto tax software like ZenLedger can streamline tax filing by automatically aggregating transactions, computing your capital gain or loss, and generating the necessary forms. And you can even find opportunities to save on your year-end tax bill!
Get started with ZenLedger today! You can use ARCH20 for 20% off any crypto tax plan until April 18th, 2023. Now we’ll go onto discuss how you may be able to deal with any large tax bills that may come up.
Handling tax liabilities
You made many wise investment decisions over the past year and are now facing a huge tax bill as a result of the capital gains that you locked in. How do you deal with this? At Arch, we’ve spoken to many customers with this problem and wanted to highlight potential paths to take below:
Paying with cash: If you have excess cash that you can use to cover your liability this is a good option. Note that even if you aren’t able to cover the full tax bill, it may make sense to pay down as much as you can with cash so that you minimize the amount you need to cover via non-cash means, which may come with fees or other consequences. The one caveat with this approach is that you are giving up optionality as you won’t be able to use this cash for any investment opportunities that may arise.
Selling assets: If you have other assets such as crypto or stocks, you can sell these assets and use the proceeds to pay off the tax liability. If you no longer believe in the upside of these assets, then this can be a good option. If these assets happen to be valued below their cost basis (price at which you acquired them), this also represents an opportunity to offset any capital gains for the next season. If the assets are valued above their cost basis, this will result in additional capital gains for the next season, which may be especially painful if it’s short-term or you have a strong conviction in the future growth.
IRS payment plans. Individuals can choose from a long-term installment plan or a short-term, 120-day payment plan. For those needing just a little extra time to pay their taxes, the short term plan may be a good option. IRS does not charge any fees, but interest and penalties will continue to accrue until you fully pay off your tax debt. If you can pay off earlier than 120 days, it’s a good thing to do so. The longer term payment plan comes with a setup fee, and has to be approved by the IRS.
Take out a loan: The IRS suggests taking out a loan as an option in the event you cannot pay your tax bill in full with cash. There are a variety of ways to get a loan, starting from asking family and friends, to a personal unsecured loan online, to a secured loan backed by your own assets (real estate, stocks, or even crypto). The exact terms of one’s loan depend on a variety of factors, but generally there is an interest rate charged from the provider, and additional fees such as those for the loan origination may apply.
If possible, it’s always better to plan ahead for tax season to avoid the financial stress that comes with not having enough to cover the tax bill. That is of course easier said than done, so hopefully this has shed some light on the options for those in need of help.