Navigating the cryptocurrency market’s highs and lows can feel like a rollercoaster ride. The market’s inherent volatility often leads to a mix of significant gains and, at times, substantial losses. But there’s a silver lining if you fall into the latter camp: Tax-loss harvesting can help you transform market downturns into beneficial tax deductions.
According to a paper published by the National Bureau of Economic Research, crypto traders are avoiding billions of dollars in tax by taking advantage of tax-loss harvesting. While the roughly $50 billion in undeclared crypto gains annually is illegal, the IRS allows tax-loss harvesting in several markets, including stocks and other securities.
This guide delves into the essentials of tax-loss harvesting, explicitly tailored for crypto users. We’ll explore how the strategy works, the ambiguities surrounding its use in crypto markets, and how you can use it to offset your losses today.
What is Tax-Loss Harvesting?
Tax-loss harvesting involves selling investments that have lost money on paper, replacing them with reasonably similar investments to preserve asset allocations, and then offsetting realized capital gains (or up to $2,000 in ordinary income) with those losses.
Let’s take a look at a quick example:
Suppose you purchase 100 crypto tokens on January 15 for $10,000 (USD). By March 30, the same 100 crypto tokens will only be worth $8,000, but you’re still generally bullish on crypto. You could then sell 100 crypto tokens, realize a $2,000 tax loss, and repurchase 100 similar tokens for $8,000. After, you could use the $2,000 to offset other portfolio gains.
This act of generating $2,000 in tax losses while maintaining similar exposure to crypto is known as “tax-loss harvesting.” The dollar value of the loss depends on your marginal tax rate. For instance, if you fall into the 35% tax bracket, the strategy will reduce your taxes by USD$700 (USD$2,000 x 35% = USD$700).
There are two caveats to keep in mind:
- When you harvest a tax loss, long-term losses must apply first to long-term gains and short-term losses to short-term gains. If there are any excess losses in one category, you can apply the losses to the gains of either type. In our example, the $2,000 is a short-term loss, so it would first offset any other short-term gains.
- You can only harvest tax losses in accounts where you incur taxes. As a result, you cannot use the strategy in retirement accounts, such as 401(k)s or IRAs, because you don’t incur taxes in these accounts in the first place.
Overall, by some estimates, these strategies can add nearly an entire percentage point to your after-tax returns, making them worthwhile to pursue!
Is Tax-Loss Harvesting Legal?
Tax-loss harvesting is a legitimate investment strategy used by financial professionals. In the stock market, platforms like Betterment and Wealthfront even go so far as to automate the tax-loss harvesting process to realize losses automatically when they make the most sense.
The only catch is what’s known as the “Wash Sale Rule.”
The Wash Sale Rule (26 U.S. Code § 1091 – Loss from wash sales of stock or securities) states:
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. For purposes of this section, the term “stock or securities” shall, except as provided in regulations, include contracts or options to acquire or sell stock or securities.
Essentially, the IRS doesn’t want you to sell a security just to realize a tax loss without changing your net economic position. In other words, you cannot sell Microsoft stock to realize a loss and then immediately repurchase Microsoft stock. But you can sell Microsoft stock to realize a loss and purchase IBM stock since your net economic position is different.
You can repurchase the same security if you haven’t owned it for 30 days before or after the purchase. So, if you sold Microsoft stock on January 1 to realize a loss and repurchased it on February 1 (31 days later), you could still harvest the tax loss. That’s because the Microsoft of 30 days ago isn’t in the same economic position as Microsoft today.
But here’s where things get a little ambiguous.
The IRS classifies cryptocurrencies as “property,” whereas the Wash Sale Rule only applies to “securities.” So, technically, you could argue that it’s legal to sell Bitcoin to realize a loss and then immediately repurchase Bitcoin under current law because the Wash Sale Rule doesn’t apply.
The government attempted to close this loophole in the Build Better Act in 2021. But while the House of Representatives passed it, the Senate defeated the bill, and crypto Wash Sale Rules remain an open question.
With that act, the government made its intention clear: to close the loophole. This intent means the safest tax-loss harvesting strategy involves replacing any realized losses with other crypto assets that are not “substantially identical,” such as replacing Bitcoin with Ethereum.
How Can You Harvest Your Tax Losses?
The crypto industry doesn’t offer robo-advisors that handle tax-loss harvesting for you, but several platforms can help you identify opportunities automatically.
ZenLedger connects your wallets and exchanges to simplify tax calculations – and offers a way to spot tax-loss harvesting opportunities across accounts. For example, if you purchased Bitcoin in one account, you could harvest the loss in another account and replace it with a different crypto asset to help lower your year-end tax bill.
You can also harvest tax losses behind the usual cryptocurrencies. For instance, several platforms are gaining popularity, making it easy to sell worthless non-fungible tokens (NFTs) and realize the tax loss. Then, instead of holding a worthless asset forever, you can realize the tax loss and offset other capital gains for the year or up to $2,000 in ordinary income.
When harvesting tax losses, you should keep a detailed record of your transactions. ZenLedger’s Grand Unified Accounting is an excellent tool to help you do just that by putting all your transactions in one location in a chronological list. That way, you can
The Bottom Line
Tax-loss harvesting is a popular strategy in both stock and crypto markets. While there’s some ambiguity surrounding the specifics of crypto tax-loss harvesting, investors following the Wash Sale Rule should be safe from the impact of any future legislation. And tools like ZenLedger make it easier than ever to implement the strategy in the most compliant way.
If you trade crypto assets, ZenLedger can also help you prepare for tax season by aggregating your transactions across wallets and exchanges. Then, you can generate the tax forms you need to file and find opportunities to harvest tax losses throughout the year.
The above is for general info purposes only and should not be interpreted as professional advice. Please seek independent legal, financial, tax, or other advice specific to your particular situation.