Cryptocurrency investors are beginning to understand the tax treatment of their investments, and its complexity compared to dealing with traditional securities.
The US tax reform passed in December 2017 established that “like kind” treatment only applies to certain real estate transactions — not buying & selling cryptocurrencies. In the past, many crypto traders took the position that any crypto not withdrawn to fiat was a “like kind exchange” and therefore did not trigger a tax event. Even before the new tax regulations, this was a dubious, if not faulty assumption that goes against the IRS view cryptocurrencies should be treated as property for tax purposes.
As property, selling any cryptocurrency whether for another coin or fiat currency triggers a capital gain or loss, depending on the cost basis from when you acquired it. If you held the investment for over a year, it would be a long term capital gain (LTCG) taxed at a reduced tax rate from your marginal rate. If you racked up capital losses, you would only be allowed to deduct a maximum of $3,000 per year from ordinary income — but could carry forward indefinitely the unused losses to take as a deduction in future years.
Like other investment assets — a breakdown of your trades during the tax year must be reported on Form 8949, including the gain or loss from each coin, not simply an overall profit/loss from your trading activities over the year. Web applications such as CoinTracking can help US investors maintain proper records of their cryptocurrency trades to simplify this process.
Incorporate an Offshore Corporation for Cryptocurrency Trading
If reporting each coin as a separate line item on your tax return sounds like a tedious and error-prone process, there is a way US persons can legally consolidate their reporting into an overall profit/loss position at the end of the year.
By incorporating an offshore corporation to conduct your crypto trading activities, you can transform capital gains & losses into “Subpart F” income. When a foreign corporation is controlled 50% or more by a US citizen or resident alien, it is considered a Controlled Foreign Corporation (CFC) and therefore still subject to US taxes. The income earned from a CFC is reported under “Subpart F” on your US tax return.
Contrary to capital gains earned directly as an individual, the IRS does not require line-by-line reporting of transactions done under a CFC. For frequent traders or daytraders, this can be a godsend that allows them to confidently file their tax return with less stress from doubts whether they have reported everything correctly.
Note that this is not a tax avoidance scheme, and the income earned by the CFC will be treated as if they were earned by the US owner as ordinary income. This structure is best for active traders, as profits from the offshore corporation do not qualify for long term capital gains tax rates, and any losses cannot be deducted against one’s US taxes until the corporation is liquidated. In other words, it only simplifies reporting, but does not reduce your US taxes. The foreign corporation is typically incorporated in a tax-neutral jurisdiction such as Belize, which does not levy local taxes on income earned inside the corporation. However, be cautious of additional US reporting requirements such as FBAR (Foreign Bank Account Reporting) which applies to foreign bank or financial accounts held directly, or through a corporation owned by US persons. An experienced attorney or CPA can guide you through the reporting requirements of trading cryptocurrencies through a CFC.
Moving To Puerto Rico Could Yield Tax Savings for Cryptocurrency HODLers
A more aggressive planning opportunity, that actually results in incredible tax savings, lies closer to home for Americans in the US territory of Puerto Rico. Puerto Rico has a vibrant international banking sector that generates employment for local residents. In fact, USD-pegged Tether is believed to be banking in Puerto Rico with Noble Bank International.
In fact, the New York Times did a piece on crypto entrepreneurs who are moving to Puerto Rico to take advantage of the tax breaks offered by the territorial government. The benefits stem from two pieces of legislation passed by the legislature in San Juan designed to attract investment from the US mainland and abroad — Act 20 and Act 22.
Act 20 allows businesspeople who move to Puerto Rico to benefit from a 4% corporate tax rate on their income earned from conducting business in Puerto Rico. Earlier revisions of this incentive required Act 20 businesses to employ a minimum number of people in Puerto Rico, but this requirement has since been eliminated. Furthermore, Act 20 can be combined with the Act 22 benefits to permit tax-free dividends to be paid to the Puerto Rican-resident shareholders of the corporation. This effectively slashes the total taxes on business income to a mere 4% in Puerto Rico with no federal income tax, compared to 20% for a US C-Corporation plus personal income taxes when the profits are distributed.
Whether you intend to start an active business or not in Puerto Rico, Act 22 will be of particular interest to sophisticated cryptocurrency investors from the US. Once you become a bona-fide resident of Puerto Rico, your dividends, capital gains, and interest from that point are shielded from any taxation by the territorial or federal government. This means any crypto you purchase after moving to Puerto Rico can grow and be liquidated fully tax free.
Any unrealized capital gains you accrued before the move are still liable to taxation by the IRS when you sell, unless you hold those investments for 10 years after becoming a Puerto Rico resident. If you sell before 10 years, the prevailing territorial tax on capital gains (currently 10%) plus the federal income tax you would have owed applies. If you sell after 10 years but before 1/1/2036, only 5% territorial tax applies. If you were an early investor in Bitcoin or Ethereum with a lot of unrealized gains, this incentive could make a lot of sense for you. Assuming you’re a long-term investor wanting to HODL, you could cash out in late-2020s or early 2030s with only 5% tax, escaping the high percentage of tax you would pay to Uncle Sam now.
Why is Puerto Rico a special tax haven for Americans? As you may or may not know, US citizens live in one of the only two countries on Earth that have citizenship-based taxation. That is, you cannot escape the IRS by taking up residence in a foreign country, unlike Canadian or European citizens who can “opt-out” of the tax system of their home country by breaking residential ties and moving to a low-or-no tax jurisdiction. Normally, Americans who become an expatriate must still report their global income to the IRS and pay federal income taxes applicable, subject to exemptions such as the FEIE (Foreign Earned Income Exemption). However, because of Puerto Rico’s special status as a US territory, the IRS does not claim jurisdiction over Puerto Rico residents. Instead, the taxing powers belong to the territorial government, which has decided to implement tax holidays to boost local employment and capital inflows.
Moving to Puerto Rico also has practical benefits, compared to somewhere further afield from the United States. San Juan (SJU), the capital of Puerto Rico, is a 3 hour flight to Miami (MIA), the closest major airport on the mainland, making it easy to visit family & friends and attend business meetings in the contiguous 48 states. Be warned, however that you cannot “trick the IRS” by becoming a Puerto Rico resident on paper and living in the US normally. To be treated as a bona-fide Puerto Rico resident for tax purposes, you must establish residential ties such as buying a house, living, and working a significant portion of the year from the island. Specifically, you must meet these requirements:
- Meet the presence test,
- Do not have a tax home outside of Puerto Rico, and
- Do not have a closer connection to the United States or to a foreign country than to Puerto Rico.
The presence test generally requires you reside in Puerto Rico for 183 days or more during the year, however, other ways to qualify are described on this IRS webpage under the title “Presence Test.”
Shield your Cryptocurrency Profits from Taxes with a Self-Directed IRA LLC
If you do not wish to move to Puerto Rico due to personal or professional obligations, or are not sufficiently invested in cryptoassets to justify the drastic move, you may consider a self-directed Individual Retirement Account (IRA) instead.
You are probably already familiar with deferring or eliminating taxes using a traditional or Roth IRA, perhaps through an investment plan set up with a traditional stock or mutual funds brokerage such as Fidelity or Vanguard. But did you know you can hold alternative investments, including cryptocurrencies, in your IRA as well?
Setting up a self-directed IRA for cryptocurrencies requires hiring a Passive Custodian for the IRA, and incorporating a US Limited Liability Company (LLC). Normally, a Custodian takes “custody” of the assets, whether they are stocks, bonds or real estate in your IRA directly and oversees the administration of the IRA, including any investments made within it.
On the contrary, a Passive Custodian holds the ownership interest in your LLC on your behalf under the IRA, and appoints you (the beneficial owner) as the manager of the LLC. Your IRA is listed as the sole owner of the LLC, and because a single-member LLC is treated as a disregarded entity for tax purposes by default, the LLC itself does not have to file a tax return. Any income “flows through” to the IRA and is deferred, or completely exempt from taxes depending whether you have a Traditional or Roth IRA.
With a Traditional IRA, you can take the principal amount contributed to the IRA as a deduction from your taxable income that year; however, the distributions are subject to taxation at your marginal tax rate at the time of the withdrawal.
With a Roth IRA, you pay taxes normally on the income you contributed to the IRA, in the year of the contribution. In return, distributions from a Roth IRA, including the principal and growth, are fully tax free if taken out after age 59 ½. Principal can be taken out anytime (including before age 59 ½) as it has already be taxed, however the income earned within the IRA cannot be taken out tax free until after age 59 ½.
A self-directed Roth IRA seems to be superior for investing in cryptocurrencies, as the profits from investing in a high-risk, high-reward asset class can greatly exceed the principal amount. It therefore makes sense to pay the taxes up-front, and benefit from tax-free withdrawals of the profits in retirement. However, other factors such as your expected income from other sources and desired state of residence in retirement, should be discussed with your tax or financial advisor before making the decision whether to choose a Traditional or Roth IRA.
A benefit of setting up the self-directed IRA structure is so-called “checkbook control” over your IRA. As the manager, you can buy and sell investments within the IRA without the approval of each transaction by the Custodian. It is therefore up to you to avoid “prohibited transactions” by the IRS, including but not limited to using the IRA assets for personal purposes.
With a great degree of freedom over how you invest the money in your IRA compared to an ordinary retirement plan, you are free to set up banking and cryptocurrency exchange accounts in the name of your IRA LLC. You can trade Bitcoin at exchanges such as Gemini, which charges under a 1% fee for buying/selling supported cryptocurrencies (BTC, ETH, ZEC and LTC, BCH coming soon, compared to a 10% commission each way for custodial Bitcoin IRAs. Essentially, your IRA LLC can trade at any cryptocurrency exchange that provides an institutional account, opened in the name of your LLC.
To reiterate, this structure requires organizing an LLC with the membership interest owned by your IRA, under a Passive Custodian. Then, you would need to open banking and trading accounts in the name of your LLC, to clearly separate activity under that legal entity, from your individual trading. Once you have purchased the cryptocurrency from an exchange, you are then free to withdraw it to a paper or hardware wallet such as Ledger for safe-keeping offline.
Get in Touch with Astute Professionals
All of the strategies described above are complex tax planning strategy tailored towards US cryptocurrency investors. From one crypto enthusiast to another, I would be pleased to connect you with professionals including attorneys, CPAs and agents who can help you set up any of these structures. Please contact me so I can answer any preliminary questions and make any referrals you need as part of my crypto consulting services.
I would like to warmly acknowledge Laura Walter, CPA of Crypto Tax Girl for providing input and feedback on this post. She is a US CPA who has produced an informative online course about cryptocurrency taxation in the US, who also provides one-on-one consultations where she helps clients calculate their crypto gains and losses and/or file their tax returns.
Image credit ccPixs.