Many short-term traders are attracted to the high-risk, high-reward volatility of crypto assets. Still, long-term investors know lasting success comes from risk management, diversification, and tax efficiency. Tax loss harvesting stands at the intersection of these three goals, enabling investors to realize tax benefits from losses while remaining diversified.
This guide delves into the fundamentals of tax loss harvesting and how it can benefit long-term crypto investors. We’ll look at practical examples, potential savings, and how you can integrate this strategy into your portfolio.
What is Tax Loss Harvesting?
Tax loss harvesting is a strategy where investors sell crypto at a loss and use the loss to offset capital gains from other investments. If the losses exceed any further gains, they can also reduce ordinary taxable income with excess losses carried over into future years. And finally, they purchase a correlated asset to replace it and maintain their asset allocation.
For example, suppose you sell Dogecoin $DOGE for a US$5,000 profit and have an unrealized US$3,000 Bitcoin $BTC loss. If you fall into the 15% tax bracket, you might owe US$750 in taxes on the $DOGE profit. However, selling the $BTC to realize the loss could offset US$3,000 of the $DOGE profit, leaving a US$2,000 net profit. As a result, you would only pay US$300 in taxes (US$2,000 x 15% = US$300), saving US$450 in taxes. Then, you replace the $BTC with $ETH (which is highly correlated) to maintain your exposure.
Deferring or Avoiding Taxes
Tax loss harvesting is typically a tax deferral strategy since you effectively alter the cost basis. If you have unavoidable gains, such as a real estate sale, you defer the taxes you owe by realizing losses elsewhere in your portfolio. But, of course, your new cost basis for these harvested losses is at the more recent lower purchase price.
That said, there are some potential ways to realize permanent tax benefits:
- If you have short-term capital gains in the current year, you can harvest losses to offset them, and the corresponding gain you owe in the future could be a long-term capital gain. As a result, you’ll pay a lower tax rate than you would have on that offset amount.
- You can offset up to US$3,000 in ordinary income, which you may need to tax at your top marginal rate. Like the earlier point, the offsetting future gain could be taxed at the lower long-term capital gains tax rate, resulting in net savings.
- You could offset short-term capital gains and ordinary income and avoid paying any tax at all in the future by donating the asset or giving it to heirs.
Beware of the Wash Sale Rule
The catch to this loophole is the “Wash Sale Rule,” which states that you cannot sell a security at a loss and buy the same or a “substantially identical” security within 30 calendar days before or after the sale. In other words, you cannot immediately repurchase the $BTC you sold in the example above and still claim the US$3,000 loss to offset your capital gain.
In conventional financial markets, investors tend to repurchase a similar security that’s not substantially identical. For example, an investor might sell an ETF tracking the S&P 500® Index to realize a loss and purchase an ETF tracking the Russell 2000® Index to replace it. These are both broad market equity indexes, but they’re not “substantially identical.”
Notably, the Wash Sale Rule applies across any accounts you own (such as an IRA or 401(k)) and any spouse’s account. Retirement accounts can also complicate matters because you will permanently disallow losses if you make the “replacement” purchase in them. That’s because these accounts already have favorable tax treatment.
While it’s a good idea to comply with the spirit of the law, some crypto experts insist that the Wash Sale Rule doesn’t apply to cryptocurrencies. The law specifically applies to “stock or securities,” while cryptocurrencies are technically “property.” And, for its part, the SEC has had a tough time proving that they are always “securities.”
It’s unclear if these arguments will hold up in court, so the safest strategy is to repurchase non-identical cryptocurrencies or wait 30 days. For instance, you might sell $BTC and purchase $ETH, which are correlated but not identical. Even if the loophole holds, legislators are actively looking to close it through new laws over the coming year.
Should You Use Tax Loss Harvesting?
Tax loss harvesting benefits investors with lots of income or capital gains to offset, as well as those that steadily make deposits over time (resulting in more harvesting opportunities). In addition, individuals who want to donate crypto assets or pass them down to heirs can use tax loss harvesting to avoid paying taxes entirely on some gains.
On the other hand, tax loss harvesting may be less appealing if you expect to be in a higher tax bracket in the future since you typically defer taxes. The strategy may also be less-than-ideal for those who need to make a near-term withdrawal or those with scattered portfolios where it’s difficult to ensure no Wash Sale Rule violations.
And, of course, tax loss harvesting also adds trading costs and complexity to the process. If you have a small portfolio or aren’t willing to commit the time to do it right, the strategy may not make sense for your specific situation.
How to Implement Tax Loss Harvesting
Tax loss harvesting is a complex strategy – especially in crypto – but it can help you defer or even eliminate taxes and boost your after-tax returns.
ZenLedger’s Tax Loss Harvesting Tool makes it easy to spot opportunities in your portfolio by highlighting positions with significant unrealized losses. The tool also accounts for your chosen accounting method. You can spot opportunities by checking in every month or a few times a year and quickly capitalize on them to reduce your taxes.
After identifying coins to sell, you can use crypto correlation tools, like the one pictured above, to find suitable replacements for harvested tax losses in your portfolio to maintain exposure. You can maintain your asset exposure best by choosing highly correlated coins.
Alternatively, you can wait 30 days to repurchase the security or reallocate cash to a completely different asset. But in these instances, you’re making a more significant change to your portfolio than simply harvesting losses for tax purposes.
Finally, it’s a good idea to work with your accountant to determine if the strategy makes sense for your tax situation and ensure that you correctly record everything. Fortunately, if you use ZenLedger, you can provide a Grand Unified Accounting report to your accountant that they can use to assess and calculate tax loss harvesting opportunities quickly.
The Bottom Line
Tax loss harvesting is more than just a savvy tax strategy; it’s a critical component of a well-rounded crypto investing approach. By strategically selling assets at a loss to offset other gains, you can significantly reduce your tax liabilities, reinvest the savings, and potentially enhance overall portfolio performance.
If you want to implement tax loss harvesting, ZenLedger’s Tax Loss Harvesting Tool can help you efficiently spot opportunities. In our comprehensive tax platform, we can help ensure you properly account for these harvested losses and keep your accountant in the loop.
This material has been prepared for informational purposes only and should not be interpreted as professional advice. Please seek independent legal, financial, tax, or other advice specific to your particular situation.