The crypto markets had a volatile 2020, and that might mean you lost money on your cryptocurrencies. Here's everything you need to know about how you can offset your crypto losses by putting tax-loss harvesting to work.
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.
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.
Does Crypto Tax-Loss Harvesting Apply to Me?
Do you have gains from other investments this year (like stocks) that you’ll need to pay taxes on for your 2020 return? If so, you can use losses from crypto for a tax win, by offsetting any gains you had in other positions and/or offset even ordinary income. You will most likely want to REALIZE enough capital losses in crypto in order to OFFSET your capital gains in stocks or other places. You can also often use up to $3,000 in capital losses towards the income you earned.
The Deadline is December 31st
Don’t delay! The deadline for realizing losses on your crypto is DECEMBER 31st. You will need to sell your crypto at a loss within the calendar year if you want to harvest those losses to offset other gains you will have to pay the IRS this year.
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)
- Last-in-First-Out (LIFO)
Traders using the FIFO method calculate capital gains or losses using the difference between the price of the sale and the earliest buy price.
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 crypto tax loss harvesting 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.
How to Use ZenLedger's Crypto Tax-Loss Harvesting Tool in 3 Easy Steps
Our tax-loss harvesting tool lets you know how many unrealized capital losses you have in each token type. Once you see this preview, you can then decide if you want to realize the loss. You can decide which token(s) you want to realize the loss on, and by how much.
Step 1: Launch the Tool
After you upload your transactions, you’ll see a menu item called Tax-Loss Harvesting on your dashboard. Click on this link and we will begin to run our tool. It will take about 15 seconds to process.
Step 2: Read the Results
The output of our tool is a Google spreadsheet that will open in a new tab of your browser. Each tab represents your unrealized capital loss.
The first two tabs are summaries of your total potential losses to harvest, organized by currency. You can toggle between LIFO, FIFO, and HIFO accounting methods in the spreadsheet. We take a deeper look at LIFO and HIFO below.
Tab 1: Summary by FIFO
This tab summarizes your losses as accrued by using the FIFO accounting method (more widely recommended by tax experts). Please note that you must be consistent year to year and between your tax-loss harvesting and your reporting on your 8949 or Schedule D. You cannot switch between these, you have to choose one and stick with it.
Tab 2: Summary by LIFO
This tab summarizes your losses as accrued by using the LIFO accounting method. Please note that you must be consistent year to year and between your tax-loss harvesting and your reporting on your 8949 or Schedule D. You cannot switch between these, you have to choose one and stick with it.
Tab 4: FIFO Ordering of Sells
This table shows you all of the coins you currently own that have an unrealized loss using the FIFO accounting method. This is the raw data we use to create your summaries on tabs 1 and 2.
Tab 5: LIFO Ordering of Sells
This table shows you all of the coins you currently own that have an unrealized loss using the LIFO accounting method. This is the raw data we use to create your summaries on tabs 1 and 2. Choose this if you want to realize all of your capital losses in crypto, or just enough to offset your non-crypto capital gains and $3,000 in income taxes.
Step 3: Realize Losses by Selling Your Crypto
Once you see where you have losses to harvest, it’s up to you to take action: Share this data with your tax professional so the two of you can decide on the best approach, or log in to your exchange(s) and sell your coin(s).
What Are The Risks Of Tax Loss Harvesting?
There are two primary risks of crypto tax-loss harvesting:
- The costs to execute the necessary trades could outweigh the savings on your tax bill from harvesting the losses. For instance, you might have to pay as much as 4% in transaction fees when buying and selling through certain exchanges.
- While tax-loss harvesting defers your capital gains, it doesn’t eliminate them permanently.
Your new cost basis will be equal to the fair market value during the previous sale when you harvest your losses and use the proceeds to purchase a replacement cryptocurrency (whether or not it’s the same asset). Your new cost basis will be lower than your original cost basis. That implies that you’re possibly setting yourself up for an even larger capital gain if you sell the new asset at a profit in the future.
One of the common questions is whether or not there is any risk of the wash sale rules applying to crypto. Now, wash sale rules specifically apply only to stocks and securities, not cryptocurrency.
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 Capital 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
The ZenLedger crypto tax-loss harvesting tool tells you what coins have unrealized losses, but we do not direct you to an exchange or wallet to sell from. This is because all your coins are in the same “accounting” bucket.
Want to try out our tax-loss harvesting tool? Click the button below to create an account.