19 Jul Tax Strategies for Crypto Losses (07-19-22)
The last few months have shown us just how volatile cryptocurrency investments can be. In November 2021, we saw the cryptocurrency market peak at about $3 trillion. Two months later, we saw the cryptocurrency market plummet over 40%, wiping out more than $1.2 trillion in a matter of months.
This can be devastating for many of our clients, but just like any boom-and-bust cycle in the stock market, it can also provide the opportunity to minimize the pain by using various tax strategies.
Harvesting losses and wash sale rules
While our clients are understandably not happy to see the value of their cryptocurrency investments plunge, in some instances, this can provide an opportunity for them to harvest losses and offset some, if not all, of their taxable income.
The only real guidance we have from the IRS is that cryptocurrency is property and not a security, the wash sale rules don’t apply (at least currently). This means taxpayers who want to harvest tax losses from the drops in the cryptocurrency market may be able to without having to comply with the 30-day wash sale period.
Under the wash sale rules, taxpayers who sell stocks and then purchase other substantially similar stocks within 30 days of the sale date may not claim a loss on their stock sale. Instead, the loss amount is added into the computation of the new stock’s basis.
The wash sale rules don’t currently apply to cryptocurrency transactions, cryptocurrency owners can sell their cryptocurrency at a loss, lock in the loss amount to apply against the taxpayer’s other capital gain, and then turn around and purchase the same cryptocurrency at the reduced rate, without having to wait 30 days to do so.
Economic substance
Even if not subject to the wash sale rules, taxpayers can only deduct losses from sales of their cryptocurrency if they can show that these transactions had “economic substance” apart from harvesting the loss. To do this, the taxpayer has to show that there was some economic risk involved before rebuying the same cryptocurrency.
Obviously, turning around and rebuying the same stock immediately would not subject the taxpayer to much risk. But given the volatility we’ve seen in the crypto world, and the $200 billion plunge in value in a single day in May of 2022, a taxpayer can probably make the argument that waiting a few days prior to purchasing more cryptocurrency placed them at an “economic risk,” and therefore they should be able to harvest the loss.
Capital losses
If the loss is a capital loss, then only $3,000 of the capital losses can be applied against the taxpayer’s ordinary income. But unused capital losses can be carried over until used.
The key to determining whether a loss is a short-term or long-term capital loss is the cost-basis method chosen by the taxpayer. If a taxpayer uses the first-in, first-out method, a long-term capital loss or gain will be generated if the taxpayer sells the cryptocurrency after a year. If the taxpayer uses a specific identification method, the taxpayer will have greater flexibility in generating a capital gain or loss.
Please don’t hesitate to contact us if you have any questions.