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Joe's Tax Troubles Trying to Cash Out His Crypto Fortune (The Bitcoin Consultancy - Issue #5)

The Bitcoin Consultancy
Joe's Tax Troubles Trying to Cash Out His Crypto Fortune (The Bitcoin Consultancy - Issue #5)
By David Veksler • Issue #5 • View online
“Joe” is a crypto one-percenter who asked for my help. He was a factory worker in Oregon when he invested $10,000 in Bitcoin. Less than two years later, his net worth in crypto is $3 million. If he traded his stash for a traditional portfolio, he should have enough to quit his factory job and live off his money for the rest of his life.
But Joe is in for a shock. His taxes are larger and more complicated than he thinks. Let’s dig into the complexities of paying taxes on crypto and present one possible solution.
[Disclaimer: I am not a CPA or lawyer, and this is not legal or financial advice.]

First problem: Joe must hurry to lock in gains
Joe knows that he needs to sell most of his crypto holdings because he is smart enough to realize that he got lucky. There are 100,000+ tokens out there, and of the 100 that Joe bought, he picked a few winners and then doubled down on them a few times. He beat 99% of other traders but, if he does not sell fast for something more stable, there is a good chance that his portfolio will crash.  
How does he know this? We looked at the best-performing coins in 2017: Ripple (360x return!, NEM, and Ardor. XRP is now 1/3rd of its 2017 peak, NEM and Ardor are about 1/10th. At least these coins had some sort of plausible business model (I think) – unlike today’s 100% hype meme tokens. Only Bitcoin and Ethereum have had lasting gains since 2017.
Joe needs to sell quickly, and he’ll have to pay taxes on his gains. Joe doesn’t want to evade taxes. But in trying to comply, he’s in for a shock.
Second problem: High marginal tax rate
As a middle-class worker, Joe is used to paying just north of 10% of his salary on taxes. But converting a large portion of $3 million to cash or traditional investments will put him in the highest tax bracket. A 37% federal tax rate plus a 9.9% state tax equals a total rate of 47%. (I’m simplifying by using a single bracket.) Even though most of his crypto earnings are capital gains, they are short-term, so they are taxed as ordinary income.
Right of the bat, Joe is down to about $1.6 million. Just barely enough to retire using the 4% rule. But Joe’s problems are just starting. 
Third problem: Calculating cost basis
To calculate his tax obligation, Joe needs to determine the cost basis and gain or loss from each sale. His initial cost basis was the $10,000 he paid for 2.5 bitcoin in 2020. But he sold that Bitcoin to convert to Tether, which he then deposited at 12+ crypto exchanges, that he used to buy over 100 different crypto assets.   Most of them crashed or stagnated, but a few (let’s say SHIB and ADA) had astronomical 1000%+ returns that added up to $3M. Joe is ahead of most traders in keeping a spreadsheet of all his current holdings, but getting an accurate cost basis of all his transactions is nearly impossible:
While Joe can export a list of transactions from each centralized exchange, he also used decentralized exchanges (like Uniswap, PancakeSwap, SushiSwap, HoneySwap, etc). While all the transactions are on the blockchain, tracking them down is hard for a non-techie. Furthermore, the USD price of each transaction is not recorded anywhere. Joe can look up the daily close of most coins using CoinMarketCaps historical snapshots, but they are inaccurate because (1) marginal altcoins are highly volatile intraday (2) Joe buys and sells when during days of extreme price moves, so the uncertainty is magnified (3) he paid as much as 30% of the spot value of some coins in transaction fees.
(If Joe is staking, yield farming, crypto lending, forking, collecting airdrops, or earning crypto from any of many other ways to make money in crypto, he owes income tax in addition to capital gains. That’s a whole other ball of wax I won’t get into now.)
An aside: Why the convoluted trading process?
If you’re not familiar with the crypto ecosystem, you may think this is a contrived example. Why does Joe need to use 12+ exchanges, convert between several tokens, and buy 100+ different assets? This is very typical for US-based crypto “traders” who follow social media recommendations. Without a fundamental strategy to guide them, investors buy the latest fad coin every week on whatever exchange is listing them. Reputable U.S.-based exchanges like Coinbase and Gemini will not list anything which the SEC might classify as “security,” and they do not do “pay to play” – where crypto projects pay exchanges to list their coins. Reputable non-US exchanges like Binance and FTX will not accept U.S. residents. This forces U.S. traders to use a VPN to register at smaller, less-reputable foreign exchanges with poor record-keeping and certainly no integration with crypto tax-tracking services like  
Since these foreign exchanges cannot accept USD from U.S. banks, Tether is used as an intermediate currency, so a typical conversion path is USD > Bitcoin > Altcoin > Tether > USD. (Coinbase added Tether support in April 2021, saving a few steps.) 
Fourth problem: Slippage
Joe has many altcoins in relatively small marketplaces. Selling those holdings will devalue the asset being sold, so Joe will get less for his coins than the market price. The price impact (aka “slippage”) depends on the ratio of the transaction value to the size of the liquidity pool (if DeFi) or order book depth (if exchange). In other words, if you try to sell large positions in low-market-cap assets, you will cheapen the coin, at least temporarily in that specific market. The price impact could be anywhere from trivial to 90%+. There are strategies for mitigating this, but for example: if Joe is legally obligated to sell $500K to pay taxes on gains of $1M, he may have to sell 60% of that $1M in crypto to pay a 47% total tax rate, leaving him with just 40%. This is only a problem with marginal assets, but that’s also where the extreme gains are.
Example of slippage - see "Price Impact"
Example of slippage - see "Price Impact"
One solution: A Charitable Remainder Trust
First, some advice for beginners: 
If you are already a crypto 1%er, good for you. But if you are just starting out and reading stories of other investors’ astronomical returns, it is essential to understand that this is a case of survivor bias. For every story of rags to riches, there are 99 stories of people who lost everything. This also applies to crypto assets. For every coin with a 100x return, 1000 tokens crashed to zero. If you like gambling, fine, but don’t pretend to be an informed investor through trading advice from YouTubers.
That said, here is one way to eliminate crypto tax liability for crypto millionaires:
This approach will allow you to retain 100% of your crypto with zero tax liability. Here’s how it works:
1: Joe creates a Charitable Remainder Trust (CRT)
2: Joe donates his cryptocurrency to the CRT. Joe receives a tax credit for his donation that he can use against future capital gains.
3: The trust can sell the cryptocurrency completely tax-free - or grow it tax-free.  There’s no longer a need to sell it to pay taxes.
4: The trust will pay an annuity to Joe and his partner for the rest of their lives. (The annuity income is taxed – but at a much lower rate.)
5: When Joe dies, any remaining funds are donated to a charity of his choice.
6: If Joe’s children don’t like the idea of leaving his assets to a charity, Joe can use the income from the CRT to pay for a permanent life insurance policy that will pay out on Joe’s death. Life insurance payouts are tax-free.
Using this CRT calculator, we can enter the numbers from Joe’s situation, and see a total tax avoidance of $600,000, a tax deduction of $221,000, and a total after-tax income of $5.4 million. Joe can live off $180K per year for the rest of his life and only pay tax on his annuity income.
I think this is a good solution for Joe’s specific situation, but I am not a tax expert and there are other ways to minimize your tax obligations.  
Here are a few things I hope you learned from this anecdote: 
1: You will need to pay taxes when you cash out your crypto, and they may raise your marginal tax rate.
2: If you want to shelter your profits, you must take action before cashing out.
3: Keep a record of all your holdings and transactions.
4: Know when to fold – and when to HODL. If you buy and hold your Bitcoin, you will not owe any taxes until you sell it.
Crypto 101, One on One – The Bitcoin Consultancy
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David Veksler

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