Introduction to Tax-Loss Harvesting
So you bought your first cryptocurrency based on the recommendation of your friend - but bought at the wrong time, and now you’re looking at a paper loss? Don’t let that unrealized cryptocurrency loss sit there - put it to work for you at tax time.
Because the IRS treats cryptocurrencies as investment properties — similar to a stock or bond — they are subject to capital gains taxes. Under the IRS’ 2019 guidance, users must record each transaction and compute the aggregate capital gain or loss each year for tax purposes. While nobody enjoys experiencing a loss, smart investors leverage any losses to offset short-term capital gains elsewhere in their portfolio — or even offset up to $3,000 of their income.
Let’s take a look at how this strategy, known as tax-loss harvesting works, and the unique rules that apply to cryptocurrency investors.
What is Tax-Loss Harvesting?
Tax-loss harvesting is the process of selling a cryptocurrency that has experienced a loss to realize that loss. By “harvesting” the loss, investors can offset taxes on both gains and income. The sold cryptocurrency can then be replaced in the portfolio in order to maintain an optimal asset allocation and expected returns.
Harvested losses can offset capital gains incurred during the year and reduce ordinary taxable income by up to $3,000 per year. 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 instance, if you have $5,000 in losses and no capital gains, you may be able to offset $3,000 in taxable income and carry forward $2,000.
Another tax-loss harvesting example is suppose that you bought coins at $10,000 in February 2020 and you’re still holding it at $6,800 today, which represents a 32% unrealized loss. You could harvest the loss by selling coins to realize the $3,200 loss and use that $3,200 to offset other taxes that you owe this year or carry those losses forward to next year.
By some estimates, tax-loss harvesting can increase after tax annual returns between 0.15% and 0.25% per year.
What If You Didn’t Have Losses For The Year?
Another savings option according to Andrew Gordon, JD/CPA, President of Gordon Law Group, an expert in cryptocurrency taxation and legal structures, is when you have gains for the year.
“If you traded a bunch of cryptos and have accrued gains during the year, then you are currently in a gain position. You can reduce your current gains by year-end by selling your crypto at a loss. You can also offset other capital gains, so it doesn’t have to be crypto, it can also reduce stocks or other securities. You can even sell your real estate to realize the loss. So again, it’s not just crypto, but crypto is a very liquid investment to use for tax-loss harvesting. After realizing the loss, investors can purchase a similar asset to maintain optimal asset allocation and expected returns.”
Tax Loss Harvesting Rules
So far, we’ve seen that crypto tax-loss harvesting can help you save some dough, but how can you exactly do it? Enter the Wash Sale rule. Here’s how you implement it.
The Wash Sale Rule
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. But, while these rules apply to stocks, the IRS considers cryptocurrencies property, rather than securities, so under the current law, the Wash Sale Rule does not apply to crypto investors.
Despite the potential for strong tax savings, cryptocurrency investors should try not to abuse the strategy. The IRS could argue that an immediate sell-buy transaction had no substantive economic value and therefore could not be used to offset capital gains or income. Even if the IRS wouldn’t win the fight, the cost of the fight might outweigh the benefits.
How ZenLedger Can Harvest Your Losses?
ZenLedger helps investors automate their tax-loss harvesting by identifying opportunities with our tax-loss harvesting tool. When you import your transactions (from your various exchanges and wallets into the ZenLedger platform, it finds every opportunity for savings and auto-fills popular IRS forms. Our tax-loss harvesting tool is free to use with all tax plans.
*The deadline for tax-loss harvesting is December 31st, don’t miss your chance to lower your tax burden!
ZenLedger generates a Google Sheet containing tax-loss harvesting opportunities based on your transactions and chosen accounting method.
How ZenLedger’s Tax-Loss Harvesting Tool Works?
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.
It’s an Easy 3 Step Process
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 ZenLedger’s Tax Loss Harvesting report is a Google spreadsheet that will open in a new tab of your browser.
Each tab represents a different accounting method - use your preferred method (most customers use FIFO, but HIFO and LIFO are also available) to see your total potential losses to harvest, organized by currency. You can toggle between accounting methods in the spreadsheet.
The summary tabs show you all of the coins you currently own that have an unrealized loss using your preferred accounting method. The other tabs show you the raw data that we use to create your summaries.
Breakdown of Accounting Methods
Our tax-loss harvesting spreadsheet tabs summarize your losses as accrued by each type of supported accounting method. Please know 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.
We’ve included the textbook definitions below for more clarity. You’ll want to consult a tax advisor to decide which method is best for you.
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) to harvest the losses.
The ZenLedger 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.
To learn more about the rules and requirements around crypto tax-loss harvesting watch this 22-minute on-demand webinar with Pat Larsen, CEO and CoFounder of ZenLedger, and Andrew Gordon, JD/CPA, President of Gordon Law Group, Ltd.
“...it’s not just crypto, but crypto is a very liquid investment to use for tax-loss harvesting. After realizing the loss, investors can purchase a similar asset to maintain optimal asset allocation and expected returns.” - Andrew Gordon, JD/CPA, President of Gordon Law Group
How Often Crypto Losses Should be Harvested?
Wash sale guidelines are not a surefire way to avert crypto tax-loss harvesting. It is advisable to record unrealized losses and be top on top of the possibilities to harvest capital losses.
Many investors wait for the end of the fiscal year (EOFY) to check their crypto investments and determine their unrealized losses to lower their tax bills. But, few investors keep an eye on market volatility throughout the year and take full advantage of crypto tax-loss harvesting. They diligently track their unrealized losses and know they have to buy when the market is plunging. Every country has its own wash sale rule and investors must do their research and acquire knowledge regarding these harvesting tax loss rules.
It gets a lot easier with ZenLedger’s free crypto portfolio tracker as it allows you to evaluate your current portfolio performance and holdings. With this tracker, you can review detailed coin and exchange allocation insights in just a few clicks.
Crypto Tax Loss Harvesting Risks
Crypto tax loss harvesting is legal but you as an investor have to adhere to the wash sale guidelines. It has its benefits but it has its downsides as well. For starters, lots of transactions mean more transaction fees and some exchanges charge around 4 percent fees. You need to factor transaction fees into the equation to ensure that they aren’t outweighing your savings.
Also, bear in mind that crypto tax-loss harvesting postpones the capital gains but doesn’t eliminate them forever. You’ll have to pay capital gains tax once you sell the crypto asset you have bought back.
The Bottom Line
Tax-loss harvesting is a great way to leverage any unrealized losses to offset short-term capital gains or income. Since crypto sales aren’t currently subject to wash sale rules, there is very little downside to the strategy and it could be used to realize a significant increase in after-tax returns. The key is exercising some discretion and using tools like ZenLedger to help.
ZenLedger easily calculates your crypto taxes and also finds opportunities for you to save money and trade smarter with our portfolio tracker. Get started for free now or learn more about our tax professional prepared plans!
Disclaimer: This material has been prepared for informational purposes only, and is not intended to provide, tax, legal or financial advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.