Most people aren’t making a ton of money in crypto right now. The market is down substantially and a lot of people – especially those who got involved in crypto more recently – are underwater. As we’ve mentioned in other articles, we have people coming to us who made millions of dollars last year who are now making a fraction of that. Crypto exchanges are freezing withdrawals and some are even going bankrupt.
In that environment, it’s easy to put tax planning on the backburner. And to an extent, that’s understandable. If you’re not making any income, then you aren’t generating income tax.
But bear markets provide unique opportunities for tax planning, especially for cryptocurrency. We’re just shifting our mindset. Instead of maneuvering to save taxes on the money you’re making right now, we’re maneuvering to save taxes on the money you’ll be making in the future. In this article we’ll be discussing one of those strategies: tax-loss harvesting.
Tax-Loss Harvesting
If your portfolio is underwater, one of the easiest ways to save money is loss harvesting. Tax-loss harvesting occurs when you sell assets for a loss to offset against capital gains.
As an example, let’s say you bought 10 Bitcoin when the price was $60,000/BTC and now the price has dropped to $20,000/BTC. That’s $400,000 of unrealized capital losses in your portfolio, which is a substantial write-off sitting there unused. Selling the Bitcoin to realize that loss is an excellent strategy and one we’d often recommend.
But you might be asking, “What’s the point? I don’t have any gains this year to offset against. And you’re only allowed to use $3,000 of losses per year against ordinary income. $3,000 isn’t worth my time. Why even bother?”
But we aren’t doing the loss harvesting for the $3,000. We aren’t even necessarily doing it for this year. We’re doing it for the future.
There is no expiration to capital loss carryovers. The losses carry forward until they are exhausted – either $3,000 at a time or when you have capital gains.
So when the crypto market does turn around and you start having gains again, you now have $400,000 of capital losses ready to be absorbed. Your next $400,000 of capital gains will all be tax free.
The Wash Sale Rule
This strategy is especially beneficial for crypto, because currently cryptocurrency is not subject to what is called the “Wash Sale Rule”. In our article on this exception to the Wash Sale Rule we noted that:
“For traditional investments there is something called the “Wash Sale Rule”. It states that if you sell a stock at a loss but then buy an identical (or “substantially similar”) stock within 30 days, you are not able to deduct the loss.
Essentially, the IRS does not want people “selling” their investments in order to harvest the losses for tax purposes but then immediately go and repurchase those same investments. If an item is sold and immediately bought again, then the taxpayer is not really and truly disposing of the asset. Perhaps on paper it shows as a sale, but in substance of course it isn’t.
Because of this, those “losses” are not deductible on your tax return. That makes sense and is fairly well-established tax law.”
Because of those limitations, tax-loss harvesting with traditional securities can be somewhat complicated. A lot can happen in the 30 days where you are not allowed to repurchase the stock. If the market goes up, you don’t have that exposure to it and lose out on those gains. Investment firms and financial advisors have to work very carefully to balance these risks and will sometimes use complex strategies to get around the wash sale penalty.
But that’s not the case with crypto – at least for now. Crypto is considered property for tax purposes, not a security (although that may change in the future). And since it is not a security, it is not subject to the Wash Sale Rule.
Again, this is likely to change in the future. Multiple members of Congress have proposed legislation that would close this loophole and subject crypto to the rule just like traditional securities.
But for now at least, this makes loss harvesting even easier. You can sell your crypto and immediately buy it back. The loss will still be generated and available for use on your tax return.
Transaction Fees Limit Tax-Loss Harvesting Benefits
The only real limitation to this strategy are the transaction fees. In that same article on the Wash Sale Rule, we noted that:
“Of course, this is somewhat contingent on scale. It is also dependent on the token itself, the network the token is built on, and where the token is held:
- Some altcoins have very high taxes as part of their tokenomics
- A token on Binance Smart Chain is going to have much lower gas fees than one on Ethereum
- An exchange like KuCoin is naturally going to have lower fees than a larger platform like Coinbase
The losses on those unrealized transactions – and the associated tax savings from them – will need to be substantial to offset against those fees and the fact that executing these trades also resets your holding period for capital gains purposes.”
Smaller losses – or losses on tokens with large “taxes” built into their tokenomics – are unlikely to be worth your while. Those fees will eat up some or all of the tax benefit generated from loss harvesting.
But for larger holdings – especially in a severe bear market – it can be an important tool and can save you a tremendous amount on your taxes.
Any accounting, business, or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.
