The key to lowering crypto taxes: Good wallet management

The IRS has offered little by way of guidance on how to effectively calculate cryptocurrency taxes and has not revised its position since 2014 (despite facing criticism for failing to do so).

There’s no shortage of articles and guides available to individuals devoted to accurately reporting their gains, but in reality, there is a lot more to understand than is often discussed. It’s not helpful to apply a “one size fits all” guide to something like taxes, particularly when each individual needs to tailor their strategy to their own activities.

Avoidance is no longer a viable tactic: the 2017 all-time highs brought with them a great deal of scrutiny from the IRS. Even if attempts to enforce regulations appeared somewhat misguided, we are seeing the enforcement nonetheless. Though figures have yet to be published, it’s likely that many investors will have attempted to offset other gains by harvesting losses arising from the 2018 bear market (thus putting themselves on the IRS’ radar for future years).

Tracking individual pieces

Not all cryptocurrencies are created equal: remember that the IRS considers it property for the purposes of taxation. Each specific coin (or fraction thereof) must be tracked from acquisition to disposal.

For instance, if you purchased three bitcoins in 2017 as the value was rising (one in January at $1,000, one in June at $3,000 and one in November at $16,000) and then three in 2018 (one in January at $15,000, one in June at $8,000 and one in November at $4,000), you would be in possession of six bitcoins. However, each of these purchases must be examined individually when filing taxes. Depending on how they are cashed out, a gain or a loss may be realized.

It remains to be seen whether methods like FIFO/LIFO (first in, first out or last in, first out) are accepted by the IRS, though it would appear that they’re currently at odds with the existing guidelines and therefore may be rejected.

Not all cryptocurrencies are created equal. (Source)

Nevertheless, with property, each piece (and the price bought/sold at) must be recorded. Few things are as important, when dealing with taxes, as maintaining a detailed audit trail that can be provided to auditors if requested (or a tax expert when preparing a report). How extensive this trail is depended entirely on the individual’s investment profile – someone that purchased 100 coins in 2010 and sold them in a single sale in 2019 will have a much easier time than an investor that makes hundreds of trades, selling cryptocurrency for fiat, goods, and services or other cryptocurrencies.

To complicate matters further, typical active traders do not keep activities limited to a single wallet, but rather have a number scattered across exchanges and devices. Crypto-oriented accounting software can be one of the most important tools for an investor. They can import historical data from various exchanges and wallets and perform all of the necessary tax calculations automatically.

When in doubt, ask an expert

Again, it appears that even regulators are uncertain as to the proper way to handle cryptocurrency taxes. The 1099-K form is traditionally used in the context of payment cards and network transactions but we are seeing it used now for regulated exchanges to maintain compliance and help legitimize the industry. Individual taxpayers are still wrestling with what to do with these forms. Often, they do not contain enough information to simply pass onto the IRS.

Accountants and tax specialists should be consulted to weigh in on the best way to interpret (or, indeed, dispute) forms that have been received by the individual.

Best practice

Regardless of uncertainty, it’s clear that ignorance isn’t a valid defense. Though regulators may not be entirely up to speed on the various mechanisms of cryptocurrency, the burden of accurately reporting lies solely with the individual. It’s up to investors to familiarise themselves with whatever information is available to them regarding their cryptocurrency taxes and to equip themselves with the right tools to calculate and to pay their dues.

Maintaining an audit trail of every transaction (for every piece of a cryptocurrency) is paramount: depending on the frequency of trading activities, a software-assisted solution will ensure that records are kept, and profits/losses calculated. Additionally, consulting with an expert on the topic will guarantee a clearer understanding of the system and how to best proceed.

The tax season may be over, but it’s never too early to begin prepping for the next one.

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DISCLAIMER: This article expresses my own ideas and opinions. Any information I have shared are from sources that I believe to be reliable and accurate. I did not receive any financial compensation for writing this post, nor do I own any shares in any company I’ve mentioned. I encourage any reader to do their own diligent research first before making any investment decisions.