This year has been tough for cryptocurrency investors, as a brutal bear market wiped about 65% from the market capitalization of Bitcoin. However, every cloud has a silver lining, and this time it comes in the form of crypto tax-loss harvesting—a strategy in which investors can sell assets at a loss to offset tax requirements.
Key Takeaways
- Crypto tax-loss harvesting allows investors to sell assets at a loss during a market low or at the end of a tax year to lower their tax liability.
- Investors can sell an unlimited amount of assets and deduct up to $3,000 to offset ordinary income on their federal taxes.
- Further crypto market losses can be carried forward into future tax years.
Tax-loss harvesting is a strategy used by investors to lower their capital gains tax liability to the U.S. government. To use this strategy, an investor will sell an investment at a capital loss to take advantage of timing in the market or for the tax year. The loss can then be used to offset capital gains from other assets that produced a profit or to offset future gains from that same investment or other profitable trades.
For example, let's say an investor bought a stock and realized $5,000 in losses with no other capital gains from it. That investor could use the loss to offset $3,000 of ordinary income for that tax year and roll the remaining $2,000 loss forward to offset future capital gains or income.
Using Tax-Loss Harvesting in Crypto
Cryptocurrency investors can use tax-loss harvesting in the same way as a stock investor.
If an investor bought $10,000 of a crypto token in April 2022 and was holding the same investment at $7,000 in December, that represents a 30% unrealized loss. By selling the investment at a $3,000 loss, they could use that $3,000 to offset other taxes owed from the financial year. The loss could also be carried forward to the next tax year.
Capital losses taken in cryptocurrency do not have to be used solely for harvesting in crypto assets. Losses can be used to decrease the tax liability on other asset classes, such as stocks, bonds, and real estate.
Tax-Loss Harvesting Has Some Limitations
Tax-loss harvesting can only be used to offset $3,000 of ordinary income ($1,500 if you are married and filing separately) after offsetting other investment gains. Because gains and losses are locked in at the end of a tax year, investors must harvest their crypto losses by the end of December.
This will work well in 2022 as the cryptocurrency market continued to hit new lows throughout the year. In December, Bitcoin still trades just below the $17,000 level after starting the year at $47,000. In a bull-market phase, however, it could be a risky strategy to harvest losses, especially if the "wash-sale" rule applies to crypto in later years (see below for more on cryptocurrencies and application of this regulation).
This Internal Revenue Service (IRS) rule prevents a taxpayer from taking a tax deduction for a loss on a security sold in a wash sale, which occurs when an individual sells or trades a security at a loss and, within 30 days before or after this sale, buys the same or a substantially identical stock or security, or acquires a contract or option to do so.
It should also be noted that stocks of companies that are involved in cryptocurrencies will be covered by the wash-sale rule. Be sure to check with an appropriate financial, accounting, and/or tax advisor if you have questions about the best use of tax-harvesting strategies.
Cryptocurrency and the Wash-Sale Rule
The IRS wash-sale rule prevents investors from taking capital losses on investments and then immediately buying them back, as discussed. Likewise, a wash sale also occurs if an individual sells a security, and the person's spouse or a company controlled by the individual buys an equivalent security during the 61-day wait period.
However, the IRS specifically states that the wash-sale rules apply to securities. Due to a lack of clear regulatory guidelines, cryptocurrencies are classed as property, not securities. This means that the wash-sale rule does not currently apply to trading in cryptocurrencies, so investors could buy their tokens back after a sale.
The Bottom Line
Cryptocurrency investors are licking their wounds after wrestling with a bear market that has lasted the whole year. Despite this, many investors are unaware of the tax-loss harvesting strategy that can help to minimize losses and lower their tax bill.
Crypto investment losses can be used to offset capital gains in other asset classes such as stocks. Investors also can use them to offset up to $3,000 per year in ordinary income. Investors seeking to use this strategy must act before the current financial year ends in December.
