As the tax year 2020 comes to a close, you may want to take note of any significant unrealized crypto losses and consider selling them to realize the loss in 2020. These losses can help offset your 2020 capital gains or ordinary income, potentially saving you hundreds or thousands of dollars, depending on your tax bracket and other factors. The tax-loss harvesting deadline for tax year 2020 is December 31, 2020.
Let's take a look at what tax-loss harvesting is and how to find opportunities in your portfolio.
What is Tax-Loss Harvesting?
Tax-loss harvesting is the process of selling a cryptocurrency that has experienced a loss in order to realize that loss. By "harvesting" the loss, investors can offset taxes on both gains and income. The sold cryptocurrency can then be replaced in the portfolio in order to maintain an optimal asset allocation and expected returns.
Harvested losses can offset capital gains and reduce ordinary taxable income by up to $3,000 per year. If you don’t have enough losses, you can carry over unused losses into future years to provide a longer-term benefit. For instance, if you have $5,000 in losses and no capital gains, you may be able to offset $3,000 in taxable income and carry forward $2,000.
The only “catch” with conventional tax loss harvesting is the so-called wash sale rule, which prohibits traders and investors from realizing a loss and immediately repurchasing the same security. Fortunately, most experts agree that cryptocurrencies aren't subject to these rules, which may open the door for traders and investors to frequently harvest losses.
How to Find Opportunities
Tax-loss harvesting requires a careful balance: You don't want to harvest losses too frequently because you will incur transaction costs each time. These transaction costs can eat into any benefits that you experience from tax losses. On the other hand, you want to harvest losses frequently enough to avoid significant losses recovering to a breakeven point.
It's also a challenge to find opportunities if you have different crypto assets spread across different platforms. You must identify trade positions at the trade lot level in order to ensure that you're selling unrealized losses rather than unrealized gains. If you have assets spread across wallets and exchanges, this level of granularity can be difficult to achieve.
ZenLedger's Tax Loss Harvesting Tool - Source: ZenLedger
The good news is that there are software tools that can help automate the process. For example, ZenLedger's Tax Loss Harvesting tool automatically analyzes your trade history and provides a list of tax-loss harvesting opportunities. You only have to execute the trades to take advantage of them for the 2020 tax season.
Other Crypto Tax Tips
Tax-loss harvesting is a great way to reduce your tax exposure, but it's not the only tax strategy. There are many different ways you can minimize your tax burden through careful planning without making any changes to your actual portfolio, as well as other ways to capitalize on unique tax rules, such as those covering donations.
Short vs. Long-term Gains
You should always try to sell long-term crypto positions held for more than a year since they generally have lower tax rates than short-term positions held for less than a year. In addition to capital gain tax rates, you may be subject to an additional 3.8% Net Investment Income Tax or other taxes at certain income levels.
Sell to Dollars vs. Crypto
You should try to set aside U.S. dollars to cover taxes after selling a crypto position for a profit rather than converting purely to another cryptocurrency. That way, you can pay your taxes for the year with those dollars on-hand and don’t have to sell short-term crypto at high tax rates. The same goes for proceeds from a fork or other transaction.
Maintain Detailed Records
Keep a record of all of your crypto transactions if you're not using an exchange that provides automated year-end tax statements. The process only takes a few minutes if you're using wallets or exchanges that support the ability to export transactions, but it can save you a lot of headaches when tax season rolls around if you’re not using crypto tax software.
Donating Crypto Assets
Donations are a great way to support a cause while saving money on your taxes. If you itemize your taxes, you can take a deduction for these donations on Schedule A of Form 1040. The amount of the deduction depends on the holding period of the crypto asset—either the fair market value or cost basis. However, if you don’t itemize, you cannot deduct them.
The Bottom Line
Tax-loss harvesting can help reduce your 2020 tax burden by taking advantage of declines in crypto asset values—but you must realize the losses before they disappear. ZenLedger automates the preparation of crypto tax returns by aggregating transactions across crypto exchanges and auto-filling common tax forms. In addition, the platform can help you identify tax-loss harvesting opportunities in the current tax year before they disappear later in the year if the market recovers.