Tax Implications When Cashing Out Cryptocurrency to Pay Off Debts, Loans, or Bills

Tax Implications When Cashing Out Cryptocurrency to Pay Off Debts, Loans, or Bills

So you invested in cryptocurrency and saw some nice gains. Now you want to cash out some of your crypto to pay off debts, loans, or bills. Great idea! Using crypto profits to improve your financial situation is smart.

But before you sell, trade, convert, or otherwise dispose of your crypto, it’s important to understand the tax implications. The IRS sees crypto as property, not currency. That means cashing out crypto for fiat currency is a taxable event, even if you’re just paying off debt!

I know, I know, taxes are no fun to think about. But ignoring crypto taxes can lead to penalties, interest, and other headaches down the road. The good news is that with proper planning, you can minimize your tax bill when cashing out crypto to pay debts and loans.

This article will walk through the crypto tax rules, planning tactics, and common questions when using crypto to pay off debt. I’ll try to explain things in simple terms, without too much technical jargon. Ready? Let’s dive in!

Crypto Disposals Are Taxable Events

First things first – let’s review the basics. According to the IRS, any time you sell, trade, swap, or otherwise “dispose” of your cryptocurrency, it triggers a taxable event[1].

It doesn’t matter if you’re exchanging your crypto for cash, paying off debt, or buying a pizza. Disposing of crypto is a taxable event, period.

The amount of tax you’ll owe depends on how long you held the crypto before selling.

• If you held the crypto for less than a year before disposing of it, short-term capital gains tax rates apply. This ranges from 10% to 37%, depending on your tax bracket[2].
• If you held for over a year before selling, long-term capital gains rates apply. This ranges from 0% to 20% depending on income[2].
• If you sold at a loss, you can claim a tax deduction to offset capital gains. There are also limits on how much you can deduct each year[3].

So the duration of holding crypto before selling is a key factor in how much tax you’ll owe. But regardless of whether it’s short-term or long-term, cashing out crypto is a taxable event.

This is true even if you’re not exchanging for dollars. For example, let’s say you trade 1 Bitcoin for $20,000 worth of Ethereum. That’s still a taxable event, even though you never converted to cash[4].

Bottom line – almost any crypto disposal triggers taxes. The only exception is gifting crypto to charity or inheriting it from someone who died[5].

Now let’s look at how this applies when cashing out crypto to pay debts and loans.

Using Crypto to Pay Off Debt is Taxable

Given that crypto disposals are taxable events, it follows that using crypto profits to pay off debt will trigger taxes too.

For example, let’s say you bought 1 Bitcoin for $5,000 years ago. It’s now worth $20,000. You sell 0.25 Bitcoin and use the $5,000 proceeds to pay off a car loan.

Even though you never converted the crypto to cash, selling 0.25 Bitcoin is a taxable event. You’ll owe capital gains tax on the $4,000 profit from the sale ($20,000 current value – $5,000 cost basis = $15,000 gain x 25% portion sold = $4,000 taxable gain) [6].

The same logic applies if you sell crypto to pay off credit card debt, student loans, medical bills, or anything else you owe money on. It doesn’t matter what kind of debt – cashing out crypto to pay debt is a taxable event.

Now, what if you use crypto profits to pay off a loan that was used to buy more crypto in the first place? For example:

• You borrow $10,000 from a crypto lending platform like Celsius Network or BlockFi.
• You use the loan to buy more crypto.
• The new crypto you bought goes up in value.
• You sell some crypto to pay back the original loan.

Even in this case, selling crypto to repay the loan triggers capital gains tax. Paying off a crypto-related loan does not avoid taxes.

The only case where selling crypto to repay debt would not trigger taxes is if the loan was used for personal expenses, and you can prove it. For example, if you take out a personal loan to pay medical bills, then later sell crypto to repay that loan. Since the loan did not create any gains, repaying it with crypto is not a taxable event.

But in most cases, using crypto profits to pay loans and debts will trigger taxes – even if you never actually converted to cash.

Tax Planning Strategies to Minimize Crypto Tax Bills

Now that we’ve established cashing out crypto to pay debt is a taxable event, let’s talk about how to minimize taxes.

The basic idea is to be strategic about which crypto you sell, how much you sell, and when you sell it. Proper planning can significantly reduce your tax bill compared to haphazardly cashing out crypto assets.

Here are some crypto tax planning strategies to consider:

1. Sell Your Biggest Losers to Harvest Tax Losses

If you have crypto assets that are worth less than what you paid for them, sell those first to realize losses. You can use realized losses to offset capital gains from other crypto sales.

For example, let’s say you have:

• 1 Bitcoin you bought for $10,000 now worth $12,000
• 5 Ethereum bought for $2,000 now worth $1,500

If you need to cash out $5,000 of crypto, sell the 5 Ethereum at a $500 loss instead of Bitcoin. That $500 loss offsets gains, reducing your tax bill.

Harvesting tax losses is a key strategy to minimize owed taxes when cashing out crypto.

2. Use the FIFO Method to Your Advantage

FIFO stands for “first in, first out” and is one of two main methods the IRS allows for tracking cost basis.

FIFO assumes you sell your oldest crypto assets first. This is advantageous when you have crypto bought at lower prices that’s now worth much more.

By using FIFO, you can selectively sell long-held crypto with a low cost basis to minimize taxes owed on the sale.

3. Cash Out Long-Term Holdings When Possible

Remember, long-term capital gains rates are much more favorable than short-term rates[2].

When possible, sell crypto that you’ve held over a year before selling newer holdings. This takes advantage of the preferential 0%, 15%, and 20% long-term capital gains rates.

For example, let’s say you need $5,000 and have two options:

• Sell 1 Bitcoin held for 8 months with a $1,000 gain
• Sell 1 Bitcoin held for 18 months with a $3,000 gain

Selling the 18-month Bitcoin triggers lower long-term capital gains tax, saving you money.

4. Consider Specific Identification to Cherry Pick Tax Lots

Specific identification allows you to cherry pick which exact tax lots to sell, maximizing control over gains and losses.

For example, let’s say you have:

• 1 Bitcoin bought in 2015 for $200 now worth $10,000
• 1 Bitcoin bought in 2021 for $55,000 now worth $60,000

If you need to sell 1 Bitcoin, specific ID allows you to selectively sell the high cost basis coin bought for $55,000. This minimizes taxable gain compared to FIFO.

The downside is specific ID is more complex to track. But for large crypto holders, the tax savings may justify the extra effort.

5. Donate Crypto to Offset Gains

Donating crypto to a qualifying charity is not a taxable event. Even better, you can deduct the current market value of the donation against your capital gains.

For example, let’s say you have $10,000 in taxable crypto gains this year. If you donate $5,000 worth of crypto to charity, you can use the $5,000 deduction to offset $5,000 of the gains.

Donating crypto lets you give to a good cause while also reducing your tax bill. It’s a win-win!

Frequently Asked Questions

Let’s wrap up with answers to some common questions about the tax implications of cashing out crypto to pay debt and loans:

Q: If I sell crypto at a loss, can I deduct the loss amount from my ordinary income?

A: No, capital losses from crypto can only offset capital gains, not ordinary income[3]. However, you can carry forward excess losses to future tax years.

Q: If I trade one crypto for another, is that a taxable event?

A: Yes, trading one crypto for another is treated as selling the original crypto. You’ll owe taxes on any capital gains from the deemed sale[4].

Q: If I take out a loan secured by crypto as collateral, is paying it back taxable?

A: No, this type of loan is not a taxable event as long as you repay the loan. Defaulting on it would trigger taxes.

Q: Can I transfer crypto to someone else without triggering taxes?

A: Yes, you can gift crypto to others or donate it to charity without owing taxes on it[5].

Q: What records do I need to report crypto taxes properly?

A: You need records proving when you acquired the crypto, your cost basis, when it was sold or traded, and the sale proceeds.

Q: What if I don’t report crypto disposals on my tax return?

A: Not reporting crypto transactions is considered tax evasion and can lead to audits, penalties, interest, and even criminal prosecution.

The Takeaway on Crypto Taxes

Cashing out crypto to pay off debt, loans, and bills is a taxable event, even though you aren’t converting to fiat currency like US dollars. But just because it’s taxable doesn’t mean you’ll necessarily owe a lot in taxes.

Here are some tips to minimize your crypto tax bill when cashing out to pay debts:

• Sell crypto held longer than 1 year whenever possible. This qualifies for lower long-term capital gains rates of 0%, 15% or 20% instead of short-term rates up to 37%.
• If you sell at a loss, claim capital losses on your tax return to offset gains. You can deduct up to $3,000 in net losses per year.
• Use specific identification to cherry pick tax lots and optimize cost basis. Sell your highest cost crypto first to minimize taxable gains.
• Donate crypto to charity. You avoid taxes and can deduct the donation against capital gains.
• Keep detailed records with cost basis, sale price, and date of acquisition/disposal. This supports accurate tax calculations.

Even if you owe some taxes, the benefits of paying off high-interest debt often outweigh the tax costs. Just be sure to set aside some crypto or cash to cover your tax liability.

The IRS treats crypto as property for tax purposes. While this creates paperwork and planning requirements, it also unlocks favorable capital gains rates and loss deduction benefits.

Work with a savvy crypto tax professional to develop a customized strategy. The tax code offers flexibility if you understand the rules and plan properly.

Yes, cashing out crypto to pay debts does trigger taxes. But a bit of tax planning can minimize how much you owe. The key is being informed so you don’t get surprised by a big tax bill down the road.

Let me know if you have any other crypto tax questions! I’m happy to explain further details on tax minimization strategies and rules around cryptocurrency.

Sources:

• https://www.cnbc.com/select/how-is-crypto-taxed/
• https://www.fool.com/investing/stock-market/market-sectors/financials/cryptocurrency-stocks/crypto-taxes/
• https://turbotax.intuit.com/tax-tips/investments-and-taxes/crypto-tax-forms/L8tQmALU3
• https://www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency-transactions
• https://www.nerdwallet.com/article/investing/bitcoin-taxes
• https://www.investopedia.com/tech/taxes-and-crypto/