The recent market downturn has led to a free fall in many asset prices. While some cryptocurrencies like stablecoins have been resilient, others have experienced a dramatic decline in value. These losses could continue as the situation evolves.
Investors that are sitting on unrealized crypto losses may want to harvest those losses to offset their taxes before the tax-loss harvesting deadline of December 31st.
Let's take a look at how tax-loss harvesting works and how you can use it to reduce your tax burden.
What is Crypto Tax-Loss Harvesting?
Tax-loss harvesting is a tax strategy whereby you sell an asset to realize a loss and lower your taxes. These losses can offset capital gains incurred during the year and up to $3,000 of ordinary income tax. If your losses exceed $3,000 and any capital gains for the year, you can roll the losses forward to future years and offset those gains.
For example, suppose that you bought coins at $10,000 in February 2021 and you're still holding it at $7,000 today, which represents a 30% unrealized loss. You could harvest the loss by selling coins to realize the $3,000 loss and use that $3,000 to offset other taxes that you owe this year or carry those losses forward to next year.
Of course, the IRS wants everyone to pay their fair share of taxes, so they introduced the Wash Sale Rule to prevent investors from incurring losses and repurchasing the same security within 30 days. While these rules apply to stocks, the IRS considers cryptocurrencies property, rather than securities, and the rules do not apply to crypto investors.
How to Harvest Your Crypto Losses
The first step in harvesting tax losses is identifying the capital gain or loss for each position in your portfolio by subtracting the current price from the cost basis. It's important to keep in mind that you must consider all of your crypto holdings — not just those in the same wallet or on the same exchange — when calculating capital gains and losses.
The cost basis is influenced by the accounting method that you use — FIFO or LIFO:
- First-in-First-Out (FIFO): Traders using the FIFO method calculate capital gains or losses using the difference between the price of the sale and the earliest buy price.
- Last-in-First-Out (LIFO): Traders using the LIFO method calculate capital gains or losses using the difference between the price of the sale and the most recent buy price.
FIFO is usually the preferred method because it minimizes the risk of short-term capital gains. In particular, you're selling the oldest positions first, which means that you're more likely to realize a long-term capital gain. It's a good idea to talk to your accountant to learn more about the right accounting method for your specific situation.
The final step in harvesting tax losses is simply selling the position for a loss, and optionally, repurchasing the position to maintain the portfolio's asset allocation. Of course, it’s important to make those moves in conjunction with your wider financial situation — the capital losses realized from cryptocurrencies can offset losses in stocks and other areas.
When to Harvest Your Crypto Losses
Most tax-loss harvesting occurs at the end of the year before the December 31st deadline. That way, you can realize any losses and use them to offset taxes in the current year. The only exceptions occur when there's a large market movement that creates potentially temporary losses, such as the COVID-19 crisis or the Great Recession in 2008 and 2009.
Since the Wash Sale Rule doesn't apply to crypto, you can easily harvest tax losses throughout the year without worrying about finding the right portfolio replacements or throwing off your asset allocations. You are effectively generating tax deductions in the current year and delaying the payment of any capital gains for future years.
The biggest drawback to tax loss harvesting is that you must pay the transaction costs associated with each trade. Depending on how you buy and sell crypto, these fees could include maker/taker fees, transaction fees, or bid/ask spread differences. The good news is that these fees tend to be less than the equity markets, making the strategy more feasible.
Crypto Tax-Loss Harvesting Tool by ZenLedger
ZenLedger simplifies tax-loss harvesting by automatically aggregating your transactions across different wallets and exchanges and identifying tax-loss harvesting opportunities from the big picture. You can run the scan on a regular basis to see what opportunities exist and then selectively execute them as you and/or your accountant see fit.
ZenLedger generates a Google Sheet containing tax-loss harvesting opportunities based on your transactions and chosen accounting method.
When tax time rolls around, ZenLedger also aggregates all of your capital gains and losses — including your harvested losses — and populates popular IRS tax forms, including Form 1040 Schedule D and Form 8949. You can provide these forms directly to your accountant to simplify your yearly taxes and likely dramatically reduce the costs of preparing them.
The final benefit of using ZenLedger is that you know everything is being done correctly and there's a defensible audit trail. At a time when the IRS is scrutinizing crypto transactions, it helps to have the documentation in place to help assist in the event of an audit. You can also help reassure non-crypto savvy accountants!
The Bottom Line
Many investors were caught off guard by the decline in asset prices and are sitting on unrealized crypto losses. Using tax-loss harvesting, you can bank those losses to offset future capital gains and income taxes. ZenLedger can help you find these opportunities and ensure that they're properly recorded on your year-end tax return to realize the benefit.
As always, it’s a good idea to consult with your accountant or other tax professionals to make the optimal decisions for your specific situation.
If you are an accountant, you may want to consider ZenLedger’s Tax Professional Suite as a way to streamline your work with crypto clients. You can easily aggregate transactions for each client and auto-complete popular tax forms, which can dramatically reduce the time it takes to calculate cost basis and add significant value to your client relationships.