It’s been a bumper year for Bitcoin from a peak price of over $19,000 to a subsequent low of less than $6,000 dollars. With many investors looking to cash out, there is growing concerns about tax liabilities from their trading activities.
In 2014, the Internal Revenue Service (IRS) issued guidance for US taxpayersregarding the treatment of cryptocurrency — Cryptocurrencies are to be treated as a capital asset. This capital gains rules apply for any gain or loss, creating a taxable event for potentially every cryptocurrency transaction.
What are Taxable Events?
It’s likely that all cryptocurrency transactions will be treated as a taxable event; some being treated as income and others being treated as a capital gain or loss.
This can include:
- Trading Cryptocurrency: Buying and selling cryptocurrency can generate a capital gain or loss. Fortunately, losses can be used to offset gains.
- Coin/Token Exchanges: Exchanging between cryptocurrencies. For example, purchasing Ripple for Bitcoin would be considered a taxable event.
- Selling Bitcoin for Fiat: When converting cryptocurrency back into fiat (USD or other sovereign currency) this is treated as a taxable event generating a capital gain/loss.
- Receiving Cryptocurrency (as a payment): If a cryptocurrency is received in exchange for a product or service or a salary/wage (it is treated as ordinary income) the value of the transaction is calculated at the fair market at the time of receipt.
- Air drops: Treated as ordinary income based on the value of cryptocurrency on the day of the airdrop. Also, at time of exchange there will be a capital gain taxable event.
- Exchanging Bitcoin for something of value: This is a taxable event and may generate a capital gain or loss.
- Cryptocurrency Mining: Mining is considered ordinary income (determined by the fair market value on the day the coin/token was mined)
The general rule is any transaction involving cryptocurrency is considered a taxable event (for US tax purposes).
However, further clarification by the IRS is required as there is not much guidance given many of the unique features of cryptocurrency (such as how to treat a chain split or fork ).
American Institute of Certified Public Accountants (AICPA) has requested on two separate occasions clarification beyond Notice 2014–21.
Even the American Bar Association’s Tax Section addressed in a letter to the IRS asking for further clarification:
Specifically, we request additional guidance that will address…new issues that are relevant to the 2017 tax year, such as chain splits , forks that have arisen subsequent to the release of the original notice
So, until further guidance is provided by the IRS, it’s safe to assume that most all cryptocurrency transactions trigger a taxable event.
6 Ways to Avoid Capital Gains Tax on Your Cryptocurrency Transactions:
It’s possible to “gift” (or give away) your cryptocurrency to a friend or family member every year (for a lifetime) without generating a taxable event.
In 2018, its possible for individuals to gift up to $15,000 without documenting the transaction. If the amount is above $15,000 then a gift tax return would need to be filled (the annual gifting exclusion limit is $15,000 per individual).
Did you know that US citizens can gift up to $11.2 million per lifetime?
One last point on Gifting — when the recipient cashes out (sells the crypto), the taxable value of the gift is determined by the market value on the day the gifting took place .
2. Self Directed IRA
Many smart investors are taking advantage of the trend to use their retirement plans as a vehicle for tax-deferred or tax-free (in the case of a Roth IRA) cryptocurrency investing using their Self-Directed IRA or Solo 401(k).
Because the IRS treats cryptocurrencies, such as Bitcoins, as a capital asset and capital assets are allowed to be managed by IRS’s, such retirement accounts are permitted to buy, sell, or hold cryptocurrencies.
Purchasing cryptocurrency with a Self-Directed IRA or Solo 401(k) plan has become very popular because all income and gains flow back into the retirement account without triggering a taxable event. The taxes are either deferred until distribution or in the case of a Roth IRA, tax-free.
If you buy your cryptocurrency within a ROTH, you pay zero tax on the capital gains earned in the account.
3. Offshore Corporation
Another option is to form an offshore IRA LLC and open an international bank account under this structure. The IRC is invested into the offshore LLC which gives you the ability to be the manager of the LLC and all the funds under the account.
If you are managing the funds under your own offshore IRC, there are IRS rules which need to be followed which include not borrowing from the account and treating investment decisions as would a professional investment adviser.
4. International Life Insurance Policy
You can also reduce or eliminate capital gains tax by setting up an international life insurance policy (minimum investment of $2.5 million) that will purchase the cryptocurrency.
The Offshore Private Placement Life Insurance can be funded with any amount of money and there are no contributions limits or distribution requirements.
The tax treatment of a private placement policy is similar in nature to a traditional IRA where tax is deferred until either disbursement or the policy is closed out.
A nice benefit of a private placement policy is if the policy is held until the person’s death, the cryptocurrency is passed to the heirs tax free.
The heirs receive the coins at the market price on the date of passing and pay zero tax on the appreciation while they were held in the life insurance policy.
5. Become a Resident of Puerto Rico
Dozens or entrepreneurs and cryptocurrency investors have established residency in the Caribbean island of Puerto Rico to take advantage of its beneficial tax system.
All US citizens must pay tax on worldwide income…with one exception — Puerto Rico sourced income is excluded from US Tax (according to IRC Section 933).
To qualify, you would need to be resident of the territory which requires spending at least 183 days a year (or more) living on the island.
Since the territory is excluded from Federal taxation, Puerto Rico is free to make their own tax laws for residents.
Puerto Rico sourced income is considered to be any capital gain or business income earned by a resident of the territory that qualifies for Act 20 or Act 22. More details regarding Act 20 and Act 22 can be found here.
6. Give Up US Citizenship
Often considered an option of last resort, you may be surprised to hear that more people than ever are renouncing their US citizenship.
Last year was another record year for citizenship reunification.
Well known celebrities are also going this route and the list includes singer Tina Turner, martial artist and actor Jet Li and co-founder of Facebook, Eduardo Saverin to name a few.
Once US citizenship is renounced the IRS no longer has any rights over your income. However, you’ll need a second passport in this case (otherwise you will be considered stateless) and be unable to travel anywhere or even leave the US.
Finally, there may be an “exit tax” imposed that would need to be paid before expatriating.
The IRS is Targeting Crypto
The IRS served a “John Doe” summons (the worst kind) to Coinbase for it’s customer list of investors who have transaction worth more than $20,000 back in 2015.
In 2015, only 900 taxpayers reported capital gains/losses to the IRS which has lead them to suspect many cryptocurrency users have been evading taxes by not reporting.
This is further supported by recent estimates that about 5% of all Americans now own Bitcoin.
If you are interested in continuing to invest and trade with cryptocurrency, it’s prudent to have a solid tax minimization plan and strategy in place to ensure you are tax compliant no matter where in the world you live — especially if you are a US citizen.