February 4, 2022

A Good Harvest Can Wash Your Crypto Gains Away

By Jose Sampedro, Senior Manager, Tax & Business Services

A Good Harvest Can Wash Your Crypto Gains Away Blockchain

Loss-harvesting is a strategy that can be used by investors to leverage the all so common dips of the cryptocurrency candle charts to move towards a more tax advantageous position. The strategy isn’t necessarily limited to year end activity; that is simply when investors and their advisors seem to focus on it.

The rhetoric of the crypto gurus might have sounded even more fervent this year. That is because this strategy may no longer be an attractive option if the “Build Back Better Act” (currently sitting with the Senate) is signed into law. Among its provisions is one subjecting crypto currency to the wash sale rules. Notwithstanding Senator Manchin’s pronouncement that Build Back Better is “dead”, applying the wash sale rules to assets like cryptocurrency could still happen.

By way of background, the Internal Revenue Service (“IRS”) has classified virtual currencies as property. This distinction means that cryptocurrency is subject to the same tax rules on capital gains/losses as other investment vehicles such as stocks, bonds, mutual funds, etc., but with one exception. Cryptocurrency is currently excluded from the “wash sale” rule which applies to financial securities.

The wash sale rule disallows a loss from the sale of securities for federal tax purposes if you buy an identical security within 30 days before or after (61-day period) the sale occurred. The reasoning for this is that the loss sale and the resulting purchase of the substantially identical security (within the 61-day period) results in an economic “wash”. In other words, the IRS believes there is no real economic loss when you sell and then reacquire the “same security”.

However, as stated earlier the wash sale rule does not currently apply to crypto holdings that are not categorized as securities. This of course fits in very well with the notoriously volatile crypto market which grants investors plenty of opportunities to harvest losses. As recent as this past month, the crypto markets were in a free fall as an assumed reaction to talks of Federal tapering, which makes this a prime time for loss-harvesting.

In practice, the mechanics of harvesting a loss are relatively straightforward. First, there should be a portfolio analysis done to identify which coins might have a relatively high cost basis compared to the current market. If the market is down-trending below the current cost basis of a particular portfolio holding, it might be time to consider harvesting a loss. Once a cryptocurrency holding is disposed of at a market low-point, and then it is repurchased its cost basis is reset to the new purchase price. When this is applied, the taxpayers can take advantage of the tax benefits in the year of the sale, net those losses against capital gains, and reduce their tax bill. Initially, harvesting short-term losses against any short-term gains might prove to be most beneficial since they are taxed at a higher rate.

A vigilant approach should be applied while attempting to harvest losses, and one must imagine how the IRS might scrutinize the transaction. This year the IRS has been signaling that they are taking a harder stance on crypto trading therefore “out of the norm” transactions might prompt for a closer look at your return. With that being said, the IRS will be paying attention to the “economic substance” of the transactions reported. As mentioned earlier, if it seems that a taxpayer is basically buying back the same exact coin that he/she has sold it could be tagged as a “wash” and be disputed. One way of avoiding those pesky IRS notices is to plan ahead, space out when the buy happens, and not just press the buy button within seconds of the sell materializing. However, because of its volatility and the fact it trades 24 hours a day, the crypto market makes it quite possible to defend a position against the IRS in the case of a dispute.

Although there are advantages associated with loss harvesting, it is always a good idea to talk to your Marcum tax advisor before applying any strategies to your portfolio that might be out of the norm.