My Simple Bitcoin Tax Strategy

Nick Rodriguez By Nick Rodriguez - Updated: September 25th, 2018
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Before investing in crypto currencies such as Bitcoin and Litecoin, understand the tax laws, and develop a common sense strategy early on to avoid potential tax and privacy issues that can hurt you do...

With the next rise of Bitcoin and other cryptocurrencies seemingly here to say and ready for the mainstream, there is a lot of optimism for the future and talk of fortunes being made. With that comes tax implications and concerns of how to protect a potential windfall from the tax man.

I won't go into the details of the specific laws, forms, or what counts as a taxable event and how much is owed, all I will say is that to the IRS Bitcoin is treated as a capital asset, and not a currency, so anytime you sell at a gain, you will owe capital gains. And yes, that means even if you purchase a good or service directly with Bitcoin technically you will owe capital gains if it gained value.

So please consult with a tax attorney or accountant if you have more specific questions, there are also plenty of online resources dealing with this subject that can lead you in the right direction, e.g. bitcoin.tax. Remember that the IRS does not consider ignorance to be a legitimate defense, so it's important to make sure you understand the tax implications of buying, selling, and holding Bitcoin.

And of course I do not advocate tax fraud or cheating, it's something that will catch up to you eventually and lead to real consequences down the road. That being said, in my opinion you should take full advantage of all legal tax "loopholes" and avoidance strategies.

So here is my personal strategy I use to minimize taxes and the risk associated with potentially ending up with a Bitcoin windfall.

1. Just hold

If you don't sell, you don't owe any taxes. It's as simple as that. Of course that means having the will power and financial discipline to resist the urge to cash out and buy a lambo, but if you can master that then you're on the road to amassing a large Bitcoin stash and staying off the IRS radar. You've probably heard the term, "Don't invest more than you can afford to lose", getting your financial house in order before investing in crypto currencies can be the difference between cashing out at the bottom at a horrendous loss or realizing windfall gains in the midst of a raging bull market. And if you're not dependent on that money in your daily life, it makes it that much easier to take the set it and forget it approach to long-term wealth, and without the added complication of taxes.

2. Keep quiet about your holdings

It goes without saying you should never divulge any personal financial information, but that's difficult because it's human nature to want to brag or tell someone about your good fortune. For liability reasons, you should never even give a hint at how many coins you own. The IRS is good at finding large fortunes, even if you have done nothing wrong and pay all your taxes, they will want to monitor those funds and be ready to pounce at the first misstep. So it's best to stay low key and under the radar.

3. Don't keep the majority of your coins on an exchange

And not just for security reasons, if the IRS decides you have committed tax fraud or owe money, they can simply freeze the account at any time and confiscate the funds. Also, anyone with a large account balance will be on the radar and become the low hanging fruit for any type of capital controls in store for us in the future. It may be paranoia, but in general it's best to keep large amounts under your own control. This ties into the point above about keeping quiet about your holdings, there is no reason to put a giant target on your back and advertise exactly how many coins you own when you don't have to. There are plenty of hardware wallets such as the Trezor, that offer top-notch security for your stash.

4. Use a more private exchange

This may be more difficult for some, but if you can, consider using an exchange that takes privacy more seriously, or at least one that's less likely to share information with the IRS. There are also p2p exchanges such as paxful, localbitcoins, or hodlhodl, that will enable you to buy and sell from individuals instead of a single organization. But keep in mind that there's a potential legal gray area using these types of exchanges because of the lack of kyc rules and reporting, especially with the p2p exchanges. And in the future options like these will only increase as we see a natural push towards more decentralized exchanges that respect privacy. After all, Bitcoin itself is a p2p currency that is meant to be used outside the bounds of the banking system.

5. Keep the coins secure, under your own control

This ties into point #3 above, and not only for security reasons. There is some confusion about holding more than $10k worth of Bitcoin on a foreign exchange, because technically it can be considered a type of foreign bank account which has to be reported to the IRS. So it's probably a good idea to keep your stash locally under your own control on a hardware wallet, I personally use a Trezor. And if you do want to use a foreign exchange, consider only using small amounts at a time so you don't go over the $10k limit.

6. Hold some Litecoin

Litecoin is technically similar to Bitcoin, and has matured along with Bitcoin over the years, establishing itself as a strategic trading partner, the silver to Bitcoin's gold. This synergy allows you to easily trade in and out of both coins and to hedge against each other. Another benefit is the ability to mix the coins, allowing you to quickly and easily cover your tracks. There is much less attention and monitoring on the Litecoin network, making it more difficult to trace addresses that have been exchanged from Bitcoin and back.

It's also important to note that exchanging between Bitcoin and other cryptocurrencies can be considered a taxable event, leading to potential capital gains. So it's best to minimize these exchanges, or do it immediately after purchasing the Bitcoin so that there are no gains.

7. Break up your holdings into multiple wallets

In general it's a good idea to break up large wallets into smaller wallets with random amounts of coins in each. This makes it harder to track and monitor your funds from a single large wallet.

Because the blockchain is public and every transaction can be easily traced, it is common practice to create a new wallet address each time you buy or receive new coins. This way it is impossible to link new wallets with old wallets you have been maintaining over the years. If you only kept your total coins in a single wallet, even a single transaction can give away your total stack.

8. Consider relocating

There's only so much you can do as an American citizen and resident to keep away from the tax man, we're almost completely boxed in. Why search for a complex tax strategy that will only get you a small benefit when the simpler answer is right under your nose. If you're ready to take it to the next level, consider relocating to another country with a lower cost of living that will enable you to live abroad on much less income without having to spend from your Bitcoin stash. This will not only allow you to use foreign exchanges and services with more privacy, but also gain access to special tax advantages as an expat.

This may be the most difficult option but with the biggest gain as far as privacy and keeping your stack intact to avoid taxes. The rising cost of living in the US may be the biggest risk you have when it comes to cashing out early.

9. Conclusion

As Bitcoin inevitably increases in value and goes mainstream, you're going to see more tax questions, confusion, and conflict as cryptocurrencies were not designed to be controlled and regulated by a single entity. It's best to build a long-term strategy now to avoid this conflict in the future.

And if that means simply putting your coins onto a wallet and forgetting about it for the next few years, it may turn out to be your best strategy. But realize that there is real money at stake now with real tax consequences.