Taxes play a critical role in investment portfolios. Long-term capital gains tax rates range from 0% to 20%, while short-term capital gains taxes could be as high as 37% for high net worth individuals—and that's just federal. Tax-efficient portfolios can mitigate the impact of taxes on returns, helping you keep your hard-fought gains.
Tax loss harvesting is a popular way to reduce taxes. By selling crypto with unrealized losses, you can realize a tax deduction to offset your capital gains or up to $3,000 in ordinary income. Traditionally, the IRS' wash sale rule prevents you from repurchasing the same asset within 30 days of selling and still taking the tax deduction... but does this same rule apply to crypto??
Let's examine the IRS' wash sale rule and its implications for cryptocurrencies.
The wash sale rule prevents taxpayers from claiming losses if they repurchase a security within 30 days—but it only partially applies to cryptocurrencies.
What is the Wash Sale Rule?
The wash sale rule is an IRS regulation that prohibits taxpayers from claiming a tax deduction on securities they sell and then repurchase within 30 days. In particular, the rule says that you cannot sell or trade a security to realize a tax-deductible loss, and within 30 days, buy a "substantially identical" security and still claim the loss.
Before you get any clever ideas, the rule also prohibits taxpayers from claiming the tax loss if they buy a contract or option to acquire a "substantially identical" security. The tax loss is also not permitted if they purchase a "substantially identical" security in a spouse's account or an account at a company they own or control.
The wash sale rule limits so-called tax loss harvesting, where investors sell stock to realize a tax-deductible loss and then replace it in their portfolio to maintain asset allocations. By realizing short-term losses, investors could abuse the system to lower their tax bill artificially and avoid paying significant amounts of capital gains taxes.
Does the Rule Apply to Crypto?
The IRS recognizes cryptocurrencies as "property" rather than "securities." As a result, in a strict sense, securities rules don't apply to cryptocurrencies—including the wash sale rule. While it's unlikely the IRS would win a court decision on the matter, excessive tax loss harvesting could still trigger an expensive and time-consuming IRS audit.
There are also signs that the government's position could become more explicit. For example, in 2021, the Biden administration's Build Back Better bill and a House Ways and Means Committee proposal included language applying the wash sale rule to digital assets. The future of these regulations is far from certain, but the government's sentiment is clear.
Some crypto transactions may qualify as securities offerings under Supreme Court guidance and SEC rules. For example, initial coin offerings, or ICOs, and certain interest-bearing tokens could be securities. In these instances, if the SEC treats these transactions as securities, the IRS may seek to apply wash sale rules.
How to Avoid IRS Problems
The current definition of cryptocurrencies suggests that you're probably safe using tax loss harvesting strategies for Bitcoin, Ethereum, and other cryptocurrencies. While these transactions could increase your audit risk, the practice is likely defensible in court, and absolute audit risks are very low for most crypto traders and investors.
If you participate in ICOs or DeFi, the wash sale rule becomes a little less clear. It's a good idea to avoid claiming tax losses from these transactions if you repurchase the crypto within 30 days. Or, at least discuss these transactions with your accountant to ensure that the potential benefit of tax loss harvesting outweighs the risk.
Crypto tax software, like ZenLedger, can help you avoid problems in the event of an IRS audit. By connecting with your wallets and exchanges, the platform aggregates transactions, calculates capital gains and losses, and auto-fills popular IRS forms. We even provide tax loss harvesting tools to identify potential opportunities to save on your taxes.
Alternatives to Reduce Taxes
Tax loss harvesting isn't the only way to reduce your tax burden. For example, you can use tax-advantaged accounts or adjust your income to minimize your tax burden during specific years. It's a good idea to keep all of these strategies in mind throughout the year to reduce your tax burden and maximize your overall after-tax income.
Popular tax-saving strategies include:
- Hold crypto for the long term. The IRS taxes crypto transactions at different rates depending on the holding time. For example, if you hold positions for over one year, you pay the long-term capital gains tax rate (typically 15%)—much less than the short-term rate.
- Choose the correct accounting method. The IRS lets you choose the accounting method you'd like to use when computing your crypto taxes. For example, you can use last-in-first-out (LIFO), first-in-first-out (FIFO), or other methods.
- Sell in low-income years. If you have unrealized gains, try to sell crypto during low-income years. That way, you fall into the lowest tax bracket and pay the least amount of short-term capital gains taxes—and potentially less in long-term capital gains.
- Use tax-advantaged accounts. Crypto investors can use self-directed individual retirement accounts (SDIRAs) to either pay taxes later or pay taxes upfront to avoid them in the future. Of course, the best option depends on your situation.
It's also a good idea to talk with your accountant to determine ways to incorporate crypto into your broader tax planning. For example, gifting or donating crypto is an excellent way to achieve charitable goals while minimizing your tax bill. You may also consider offsetting crypto gains with losses from stocks or other assets.
The Bottom Line
The IRS' wash sale rule prevents taxpayers from claiming tax deductions from investment losses when they replace them within 30 days in their portfolio. While the rule may not apply to some cryptocurrencies, tax loss harvesting could increase your audit risk, and several crypto transactions could qualify as securities transactions.
ZenLedger can minimize your audit risk by ensuring that your taxes are correctly filed each year. Sign up today!