ALERT: THE BIDEN INFRASTRUCTURE BILL INCLUDES PROVISIONS THAT INCREASE THE REPORTING REQUIREMENTS FOR CRYPTOCURRENCY TRANSACTIONS. CONTACT US FOR MORE INFORMATION
When it comes to tax losses on bitcoin and other cryptocurrencies, you’ll find in this article an escape from a tax-loss rule that does not allow you to deduct a tax loss. Yes, you read that right! The tax code has rules that don’t allow current deductions for tax losses.
Let’s start with this: you are not cheating when you use a loophole.
The Merriam-Webster dictionary defines “loophole” as a means of escape.1
In its second definition of loophole, Merriam-Webster says it’s a small opening to admit light and air or to permit observation.2
Background
About Harvest Tax Loss on Bitcoin and other Cryptocurrencies
In The IRS is interested in your Cryptocurrency activities! we explained the federal income tax angles for cryptocurrency transactions. As noted in that article, a key point is that the IRS currently classifies cryptocurrencies as “property.”
That means you must recognize a tax gain or loss each time you make a transaction involving a
cryptocurrency that is held in taxable form.
This “escape” article explains a favorable tax twist for cryptocurrency transactions that trigger tax losses. Here’s the story.
Dreaded Wash-Sale Rule Applies to Losses from Securities Sales
When you make an ill-fated investment in a security held in taxable form, such as in a taxable brokerage firm account, a saving grace is that you can claim a tax-saving capital loss deduction (within limits) when you sell the loser investment. Right?
Not necessarily.
For federal income tax purposes, the dreaded wash-sale rule can disallow your loss if, within the 61-day period beginning 30 days before the date of the loss sale and ending 30 days after that date, you acquire substantially identical securities.3
The tax theory behind the wash-sale rule is that the loss from selling a security and acquiring the same or a substantially identical security within the 61-day window adds up to an economic “wash.”
When the wash-sale bites you, the tax code disallows the tax loss (and, of course, the tax savings). Instead, the disallowed loss is effectively added to the tax basis of the acquired stock or security that triggered the wash-sale rule.4
Example. Tim paid $100 for a publicly traded stock that he sells today for $80. Ten days from now, Tim buys the same stock for $90. Tim may not deduct the $20 loss ($80 – $100). Instead, he has to add the $20 loss to the $90 he paid for the replacement stock. His basis in the new stock is $110 ($90 + $20).
Cryptocurrency Losses Are Exempt from the Wash-Sale Rule
Because cryptocurrencies are classified as “property” rather than as securities, the wash-sale rule does not apply if you sell a cryptocurrency holding for a loss and acquire the same cryptocurrency before or after the loss sale.
You just have a garden-variety short-term or long-term capital loss depending on your holding period. No wash-sale rule worries.
This favorable federal income tax treatment is consistent with the long-standing treatment of foreign currency losses.5
That’s a good thing, because folks who actively trade cryptocurrencies know that prices are volatile. And this volatility gives you two opportunities:
- profits on the upswing
- loss harvesting on the downswing
We examined your profits in The IRS is interested in your Cryptocurrency activities!
Now, let’s take a look at the harvesting of losses:
- On day 1, Lucky pays $50,000 for a cryptocurrency.
- On day 50, Lucky sells the cryptocurrency for $35,000. He captures and deducts the $15,000 loss ($50,000 – $35,000) on his tax return.
- On day 52, Lucky buys the same cryptocurrency for $35,000. His tax basis is $35,000.
- On day 100, Lucky sells the cryptocurrency for $15,000. He captures and deducts the $20,000 loss ($35,000 – $15,000) on his tax return.
- On day 103, Lucky buys the same cryptocurrency for $15,000.
- On day 365, the cryptocurrency is trading at $55,000. Lucky is happy.
Observations
Assuming Lucky had $35,000 in capital gains, Lucky deducted his $35,000 in cryptocurrency capital losses.
If he had no capital gains, he had a $3,000 deductible loss and carried the other $32,000 forward to next year.
On day 365, Lucky has his cryptocurrency, which was his plan on day 1. He thought it would go up in value.
It did, from its original $50,000 to $55,000.
Lucky’s tax basis in the cryptocurrency on day 365 is $15,000.
Here’s what Lucky did:
- He kept his cryptocurrency.
- He banked $35,000 in losses.
Be Alert
Losses from crypto-related securities, such as Coinbase, can fall under the wash-sale rule because the rule applies to losses from assets classified as securities for federal income tax purposes. For now, cryptocurrencies themselves are not classified as securities.
Planning point. If you want to harvest losses, make sure you hold a cryptocurrency and not a security.
What Does the Future Hold?
Good question. As you probably know, the IRS is hot on the trail of cryptocurrency gains that are not being reported on tax returns.
The agency is supposedly devoting substantial resources to the issue. As part of a general crackdown, it’s possible that cryptocurrencies could be reclassified as securities and thereby made subject to the dreaded wash-sale rule.
We think that would require a tax law change rather than just something coming from the IRS. Stay alert congress is discussing tightening the laws on Crypocurrency.
Takeaways
Under the law as written today, it’s clear that cryptocurrency losses are exempt from the dreaded wash-sale rule because cryptocurrencies are not classified as securities for federal income tax purposes.
If you have capital gains that need shelter, take a close look at cryptocurrency tax-loss harvesting. It’s a great tax reduction tool.
Of course, for the harvesting strategy, we assume you are already a cryptocurrency user or investor. We don’t suggest that you jump into cryptocurrency for the purpose of tax loss harvesting.
Read all our latest articles on cryptocurrency taxes.
1 Merriam-Webster definition of loophole.
2 Ibid.
3 IRC Section 1091.
4 Reg. Section 1.1091-2.
5 Rev. Rul. 74-218