{"id":5175,"date":"2024-05-29T08:32:24","date_gmt":"2024-05-29T12:32:24","guid":{"rendered":"https:\/\/coincentral.com\/?p=5175"},"modified":"2024-05-30T18:03:06","modified_gmt":"2024-05-30T22:03:06","slug":"3-common-cryptocurrency-tax-loopholes-dont-work","status":"publish","type":"post","link":"https:\/\/coincentral.com\/3-common-cryptocurrency-tax-loopholes-dont-work\/","title":{"rendered":"3 Common Cryptocurrency Tax \u201cLoopholes\u201d and Why They Don\u2019t Work"},"content":{"rendered":"

Cryptocurrency traders once enjoyed a relatively regulation-free investment environment. Back in the early days of Bitcoin, only the most tech-savvy investors even knew it existed. As cryptocurrency creeps further into the mainstream, however, regulatory agencies are developing increasingly sophisticated policies regarding digital currency.<\/span><\/p>\n

The Internal Revenue Service (\u201cIRS\u201d) first announced how and why cryptocurrencies are to be taxed with a brief policy statement in 2014. Much to the agency\u2019s dismay, however, almost nobody has paid their taxes on digital currency investments. Now, the IRS is actively pursuing cryptocurrency investors who have failed to report their Bitcoin earnings.<\/span><\/p>\n

We all reminisce about the good old days. After all, life was so much simpler for virtual currency investors when the IRS was in the dark about the billions of dollars being earned on cryptocurrency exchanges. Many investors still believe that cryptocurrency exchanges fall under loopholes in the tax code that exempt them from taxation. However, nothing can be further from the truth.<\/span><\/p>\n

You may hear rumors within the cryptocurrency community that lead you to believe you can take advantage of tax loopholes to avoid paying taxes on your digital currency exchanges. Unfortunately, this is little more than wishful thinking. This article addresses some of these rumors and clarifies how and why they don\u2019t work.<\/span><\/p>\n

Evading taxes, even accidentally, can land you in serious hot water. However, smart tax planning can minimize your liability to the IRS.\u00a0<\/span><\/p>\n

1. Buying Cryptocurrency Through Your Retirement Account<\/span><\/em><\/h2>\n

Most of us know that retirement accounts like IRAs, 401-ks, or ROTH give tax breaks for people saving for retirement. As a result, some cryptocurrency investors believe that they can avoid paying taxes on their virtual currency exchanges by purchasing the assets through their retirement accounts. However, this is easier said than done.<\/span><\/p>\n

If you are an American citizen or permanent resident and you want to buy cryptocurrencies through your IRA, you must first get a unique type of retirement account.\u00a0 It is often referred to as a self-directed or checkbook IRA (the most common one).\u00a0 You may also qualify for a self-directed 401k or SEP, depending on our business structure. These types of accounts come with a variety of restrictions as well.\u00a0 There are several types of transactions that are expressly forbidden and completing any of them may invalidate your entire transaction.\u00a0 This will result in it being taxed as a distribution, with additional penalties for early distribution tacked on as well.<\/span><\/p>\n

You may even consider setting one up offshore, but this adds even more complications to the whole process and is usually avoided.<\/p>\n

Sounds complicated? It is. You will definitely need the assistance of a professional. The process does have a significant cost to get started and requires some careful planning to get the maximum benefit from it. You may also find yourself with a very limited number of exchanges that you can operate on, as you will need to set up an institutional account rather than a personal one.\u00a0<\/span><\/p>\n

Complexity, expense, and potential fraud are not the only problems with this scheme. Also, since this process requires you to become the manager of your own investment account, you\u2019re not allowed to personally benefit from the investments. IRS rules prevent you from borrowing from the account or otherwise profiting from it personally, just like any other professional investment advisor. Furthermore, total annual contributions to your IRAs cannot exceed a combined $5,500 if you\u2019re under age 50, and they\u2019re capped at $6,500 once you\u2019re older.\u00a0 Caps on some of the other plans are much higher, but typically so is the paperwork.
\n<\/span><\/p>\n

They do have one place where they shine. If you are leaving a job with a 401k, you can potentially roll your 401k over into a self-directed IRA and then invest in cryptocurrency. Just make sure you practice good risk management and understand that values can crash quickly.<\/p>\n

2. Buying Cryptocurrency Through Your Life Insurance Policy<\/span><\/em><\/h2>\n

Life insurance policies can have tax breaks similar to retirement accounts. For example, if you set up a private placement life insurance policy, hold it for a period of time, and then cash it out, you are entitled to tax deferral similar to a traditional IRA. You\u2019ll still pay capital gains tax, but you can defer your tax liability until a later date. There\u2019s no tax break, just a deferral.\u00a0<\/span><\/p>\n

But what if you never cash out your policy? If you hold virtual currencies in your life insurance policy until your death, it is passed to your heirs. Like other property conveyed through life insurance, your heirs wouldn\u2019t have to pay taxes on any increases in the value of the virtual currencies held in the policy. Sounds great, right? After all, isn\u2019t the whole point avoiding paying capital gains on your cryptocurrency earnings? Sure, except for one big problem: you\u2019re dead. What\u2019s the point of avoiding taxes if you\u2019re never able to spend the money you\u2019re trying to hide from the IRS? You might as well just give the IRS its cut and enjoy life while you\u2019re still living it.\u00a0<\/span><\/p>\n

Leaving cryptocurrencies to your heirs sounds like a nice way to provide for your family after you\u2019re gone. However, most private placement policies require an investment of at least $500 thousand before they will even begin the conversation. This minimum investment requirement excludes most of us from even attempting to jump through all the hoops necessary to participate in this scheme, so it\u2019s better to save time and heartache and just pay your taxes.<\/span><\/p>\n

As cryptocurrencies continue to build wealth, this area will see a lot more attention as more and more investors will hit numbers that qualify for the minimums.\u00a0 Make sure you find a professional who truly understands these transactions to avoid getting hit with penalties.<\/p>\n

3. Claiming the Like-Kind Exchange Exemption<\/span><\/em><\/h2>\n

In the 2014 IRS policy statement, the agency classified digital currencies as property. This led many investors to believe that swapping Bitcoin for other virtual currencies like Ethereum, Bitcoin Cash, or Ripple, qualifies as a like-kind exchange under Section 1031 of the tax code. A 1031-like-kind exchange involves trading one kind of business or investment asset for another. For example, if you own an art gallery and swap a painting that your customers detest for a sculpture you expect will draw a crowd, you pay no taxes on the exchange. Tax liability arises when you sell the sculpture, but so long as the two pieces of art are of the same nature of character you can defer paying taxes on the sculpture until it sells.<\/span><\/p>\n

Investors who sold their cryptocurrency assets before 2018 often argue that they should be covered by the like-kind exchange exemption because cryptocurrencies have the same nature or character. However, this is not how the IRS treats virtual currencies. Dispensing of your Bitcoin \u2013 whether for U.S. dollars or other virtual currency \u2013 is a taxable event. This is true whether you buy a cup of coffee or the hottest new alternative coin.<\/strong> The transaction doesn\u2019t qualify as a swap of property-for-property. Rather, it\u2019s treated as a sale immediately followed by a purchase.<\/span><\/p>\n

For investors planning to claim the like-kind exchange rule for cryptocurrency trades in the future, the 2018 federal tax reform has brought rain to the parade. Among the several changes to the federal tax code passed in the last days of 2017, Congress expressly limited Section 1031 exchanges to apply to real estate only. This closed the like-kind exchange loophole entirely, at least so far as it may have applied to cryptocurrencies in the past.<\/span><\/p>\n","protected":false},"excerpt":{"rendered":"

Can you take advantage of tax loopholes to avoid paying taxes on your digital currency exchanges? See three of the most common ones and why they don’t work.<\/p>\n","protected":false},"author":8998,"featured_media":25341,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"inline_featured_image":false,"iawp_total_views":7,"footnotes":""},"categories":[5714],"tags":[5785,5795,5843],"class_list":{"0":"post-5175","1":"post","2":"type-post","3":"status-publish","4":"format-standard","5":"has-post-thumbnail","7":"category-articles","8":"tag-fundamentals","9":"tag-investments","10":"tag-taxes"},"wppr_data":[],"yoast_head":"\n3 Cryptocurrency Tax \u201cLoopholes\u201d and Why They Don\u2019t Work<\/title>\n<meta name=\"description\" content=\"Can you take advantage of tax loopholes to avoid paying taxes on your digital currency exchanges? 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