Update: As of November 10, 2021, Congress is in the process of considering legislation to preclude loss-harvesting through cryptocurrency sales. Congress is also considering other amendments to the Tax Code and other laws to address cryptocurrency specifically. As this is a rapidly developing issue, it is critical that you consult with a tax attorney or other professional about your specific situation and the current state of the law before making any transactions or business decisions.
More than half-way through 2021, cryptocurrency remains an extremely popular investment. Although volatile and subject to unpredictable regulation (yes, that means China), the market has experienced substantial growth. Exchanges like Coinbase and integration with PayPal make owning, trading, and speculating in cryptocurrency easy. Sophisticated investors have even added cryptocurrency into their self-directed retirement portfolios, banking on the continued growth and popularity of the decentralized exchange medium.
As I have previously written, the IRS is keeping a close eye on cryptocurrency investors, transactions, and markets, looking to capture taxes on hundreds of millions in underreported or unreported income. In other words, crypto taxes are going to be an issue for many in the coming tax years, especially after the Biden administration’s mandatory $10,000 or more transaction reporting rule goes into effect in 2023. However, with proper planning and strategy, there are ways to reduce your tax liability even if you are planning to liquidate your crypto positions in the near term.
As a basic matter, know that the IRS classifies cryptocurrency as “property,” which means that it is subject to capital gains tax. General capital gains reduction strategies work for cryptocurrency as well as they do for more traditional property like investment real estate, stocks, and bonds. For instance, waiting at least 365 days to sell lets you take advantage of the lower long-term capital gains tax rate. Selling in a lower income year where your overall income puts you in a lower tax bracket is another strategy.
One advanced tax strategy involves taking advantage of the so-called wash sale rule. Or rather, it is taking advantage of the fact that the wash sale rules does not apply to cryptocurrencies (yet). Under Treasury Regulation 26 CFR 1.1091-1, an investor cannot sell “stock or securities” at a loss, use the loss to reduce taxable income, and then immediately repurchase the stock or security. Under the wash sale rule, there is a 30-day waiting period before purchasing the same or substantially the same stock or security – if an investor repurchases the security within the 30-day restricted period, the loss will be added to the cost basis of the repurchased security and reduce capital gains on the sale of the repurchased security, but it will not be treated as an investment loss to reduce general tax basis. In other words, you cannot manufacture losses in a bear market to reduce your taxable income that you receive from other investments, rentals, or wages.
The IRS has been clear that cryptocurrency is treated as “property” for tax purposes. However, whether it is a “stock or security” remains unanswered and both IRS Notice 2014-21 and the recently amended FAQ are silent on the issue. There is no express definition of “stock or securities” for the purposes of the wash sale rule. Looking elsewhere in the Internal Revenue Code, the definitions of stock and securities in various other sections include traditional shares, notes, bonds, and the like. Indeed, in 1988 the United States Tax Court adopted a narrow interpretation of the Code, holding that stock options were not considered “stock or securities.” Gantner v. Commissioner (91 T.C. 713 (1988). Congress responded by amending the wash sale rule to expressly include stock options, but still did not enact a definition of “securities” for the purpose of the rule.
Based on the current Code and Regulations and the lack of IRS guidance on the issue, there is a strong argument that cryptocurrencies are not “stock or securities” for the purposes of the wash sale rule. What this means is that crypto investors can take advantage of loss harvesting to accrue losses and use those losses to offset income. For example, if you buy one Bitcoin for $30,000 and the next day the price drops to $20,000, you can sell the Bitcoin at a loss of $10,000, “harvest” the loss, and repurchase the Bitcoin for $20,000 shortly thereafter. You still own 1 Bitcoin, but now you have accumulated a loss that you can use to offset capital gains income.
If your losses exceed capital gains, you can use up to $3,000 of loss to reduce regular income. Any excess loss can be carried over to future years to offset future gains.
At the same time, the Securities and Exchange Commission (“SEC”), the Commodities Futures Trading Commission (“CFTC”), and certain United States courts have ruled that cryptocurrencies are indeed “securities” within those Commissions’ regulatory scope. This regulatory effort was generally to stem the fraud and abuse through “initial coin offerings” or ICOs that sought to evade strict regulations designed to protect investors. While there is currently no indication that the IRS would consider cryptocurrency as “stocks or securities,” there is precedent for that conclusion from these other agencies and remains possible that the IRS could issue supplemental guidance and interpretations to that effect.
At the time of this writing, the IRS has not issued any such interpretation and savvy investors can consider the loss harvesting strategy if appropriate for their particular situation. As with all cryptocurrency transactions, good record keeping is paramount. It is especially critical to have accurate records to substantiate your losses if you are repurchasing the same crypto. Good and accurate records are the best tool in defending your position to the IRS, should the IRS take a position and disallow your claimed losses.
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Disclaimer: This guide is for general informational and promotional purposes only. Nothing herein constitutes legal, investment, or tax advice. Every situation is different and faces its own unique set of challenges. Do not take any action or sign any contract until you have obtained specific guidance from a qualified professional.
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