Cryptocurrency investors are often referred to as buy-and-hodl investors, where "hodl" stands for "hold on for dear life" due to the market's significant volatility. While nobody enjoys experiencing a loss, smart investors leverage any losses to offset short-term capital gains elsewhere in their portfolio — or even offset up to $3,000 of their income.
Let's take a look at how this strategy, known as tax loss harvesting, works and the unique rules that apply to investors involved with cryptocurrencies.
What is Tax-Loss Harvesting?
Tax loss harvesting is the practice of selling an asset that has declined in value in order to realize a loss. These losses can offset any short-term capital gains for the year and/or ordinary taxable income by as much as $3,000 per year. By some estimates, tax loss harvesting can increase after-tax annual returns by between 0.15% and 0.25% per year.
After realizing the loss, investors can purchase a similar asset to maintain an optimal asset allocation and expected returns. The only catch is that the IRS' Section 1091 wash sale rules prevent repurchasing a "substantially identical" security 30 days before or after the sale. They want transactions to have a real economic value rather than a tax-only rationale.
The IRS rule specifically reads:
In the case of any loss claimed to have been sustained from any sale or other disposition of shares of stock or securities where it appears that, within a period beginning 30 days before the date of such sale or disposition and ending 30 days after such date, the taxpayer has acquired (by purchase or by an exchange on which the entire amount of gain or loss was recognized by law), or has entered into a contract or option so to acquire, substantially identical stock or securities, then no deduction shall be allowed under section 165 unless the taxpayer is a dealer in stock or securities and the loss is sustained in a transaction made in the ordinary course of such business.
Many stock market investors purchase different equities or indexes to avoid the wash sale rule. For example, they may sell an index fund for a loss and replace it with a different index fund with similar risk and return characteristics but different security holdings. This preserves the portfolio's overall dynamics without violating the IRS' rules.
Special Tax-Loss Harvesting Rules for Cryptocurrencies
The IRS makes it clear that the wash sale rule only applies to "shares of stock or securities" in Section 1091. At the same time, the IRS made it clear that cryptocurrencies are "property" in its 2014 guidance. This means that cryptocurrencies may not be subject to the IRS wash sale rule, making tax loss harvesting a lot easier.
The specific IRS guidance on cryptocurrency states:
For federal tax purposes, virtual currency is treated as property. General tax principles applicable to property transactions apply to transactions using virtual currency.
Cryptocurrency investors could theoretically sell every losing cryptocurrency position and simply buy it back again to harvest the loss. Since these losses can carry forward, they could even "bank" them to offset future capital gains or income down the road. Aggressive investors could use this strategy to avoid paying taxes — a primary reason for the wash sale rule.
Despite the potential for strong tax savings, cryptocurrency investors should try not to abuse the strategy. The IRS could argue that an immediate sell-buy transaction had no substantive economic value and therefore could not be used to offset capital gains or income. Even if the IRS wouldn't win the fight, the cost of the fight might outweigh the benefits.What's the safest approach to tax loss harvesting?
The best way to avoid any issues with the IRS is to sell a cryptocurrency into a highly-correlated intermediate currency before repurchasing the original currency. That way, there's a layer between the sale and repurchase. It's also a good idea to space out the transactions to make it clear that there's an "economic significance" in the eyes of regulators.
It's also important to keep in mind that the IRS is expected to issue new guidance for cryptocurrencies over the coming months, which could entail changes to tax loss harvesting rules. As a result, cryptocurrency investors should keep an eye on evolving regulations and ensure that they're on the right side of the law to avoid any losses.
How ZenLedger Helps Harvest Tax Losses
ZenLedger helps investors automate tax loss harvesting by identifying opportunities with a Tax Loss Harvesting Tool and auto-filling popular IRS forms during tax season. By importing transactions across exchanges and wallets, the platform finds every opportunity and ensures that your tax return is accurate to avoid any issues with the IRS.
The Tax Loss Harvesting Tool involves four easy steps:
- Launch the Tool - Select the Tax Loss Harvesting menu item to begin analyzing transactions for opportunities.
- Read the Results - Open the Google Sheet that opens in a new browser tab containing unrealized losses.
- Realize the Losses - Sell cryptocurrencies on the spreadsheet to realize and harvest losses.
- Repurchase the Assets - Repurchase cryptocurrencies using the strategy of your choice to maintain asset allocations.
Example of Tax Loss Harvest Report from ZenLedger
ZenLedger incorporates these realized losses into your end of year reports. When you're ready, the platform auto-generates popular IRS forms, including Form 1040 Schedule D and Form 8949, which can be provided directly to your accountant or be imported into TurboTax. There's even an audit trail in place that can help you in the event of an IRS audit.
The Bottom Line
Tax loss harvesting is a great way to leverage any unrealized losses to offset short-term capital gains or income. Since they aren't subject to wash sale rules, there is very little downside to the strategy and it could be used to realize a significant increase in after-tax returns. The key is exercising some discretion and using tools like ZenLedger to help.
Sign up for ZenLedger to identify potential opportunities using the Tax Loss Harvesting Tool and automatically incorporate harvested losses into year end tax forms.