With the IRS and Treasury Department looking to crack down on cryptocurrency transactions to narrow the tax gap, investors should take care claiming losses when selling their virtual currencies.
- A drop in cryptocurrency prices could prompt people to sell their holdings, but they should be aware of the tax consequences.
- Some argue the wash-sale rule—which prohibits investors from taking losses to lower their tax bills and then quickly buying back the same security—doesn’t apply because virtual currencies are not considered securities or stocks.
- Tread carefully, though, because others say the IRS has other tools it can use to disallow those losses.
Some investors, for example, may have taken advantage of the drop in Bitcoin to below $30,000 last month from more than $60,000 in April to practice “tax-loss harvesting”—selling an investment like crypto for a loss in order to offset taxable capital gains.
They would have been able to do so because the IRS classifies virtual currencies as property or assets, rather than as stocks or securities. That means that losses on cryptocurrencies are treated differently than losses on stocks, where so-called wash-sale rules clearly apply.
A wash sale occurs when investors sell stocks or securities at a loss and buy the same ones within 30 days before or after the sale date. If that occurs, they’re not allowed to deduct the loss from income. Instead, they add the loss to the basis of the new purchase, effectively raising the price of the new stocks or securities, and use the date of the original purchase for the transaction. (If you’d held an asset for a year, for instance, but sold it at a loss and repurchased it again less than 30 days later, the new purchase would be considered to have been held for more than a year, allowing you to pay a lower long-term capital gains tax rate.)
The wash-sale rule is intended to prevent people from selling securities for no other reason than to generate losses that could be used to reduce their taxable income. Before the law was put in place in 1954, investors could sell a losing stock and then turn around and immediately buy it again, effectively locking in the loss in order to reduce their taxes.
The tax law that “governs wash sales does not mention anything about ‘property.’ It only talks about stocks and securities,” said Shehan Chandrasekera, head of tax strategy at CoinTracker, which makes tools to assist cryptocurrency investors, in an email. “We see crypto investors using this strategy to harvest losses in crypto.”
If a sale is not considered by the IRS to be a wash sale, investors can legally harvest, or collect, those losses to offset any taxable capital gains, thereby reducing their tax liability. That may be what some cryptocurrency holders have been hoping will happen this year if they sell their virtual currency holdings at a loss.
With the threatened crypto crackdown in Washington, however, there’s no guarantee the status quo will continue. Some people may be avoiding taxes by moving assets into the crypto economy, Treasury officials wrote in May. The IRS even tweaked its cryptocurrency question last month at the top of its 1040 tax form draft for 2021 to make it clear it wants to tax cryptocurrency transactions.
Rules Could Change
Technically, it is true that cryptocurrency is neither a stock nor a security. However, some accountants warn there is enough ambiguity that, in the future, the IRS may contend that cryptocurrency deals should be treated like stocks or securities for tax purposes.
“The IRS has argued, and courts have agreed, that other types of investments are subject to wash-sale rules, even if technically they don’t fit that definition,” said Paul Beecy, tax partner and New England tax practice leader at Grant Thornton LLP.
For example, Treasury bills are securities and so are Treasury futures, because security futures products are considered both securities and futures products, according to the Commodity Futures Trading Commission. Futures fall under the wash rule because they are agreements to buy or sell a particular commodity asset or security at a predetermined price at a specified time in the future, Beecy said.
The IRS could make other arguments to tax cryptocurrency transactions as well, Beecy said. “The IRS often looks at a series of rules that were built by case law and other guidance to look at the substance of the transaction,” he said. “It could look and ask, ‘Was there an economic consequence to the loss?’ And if the answer is, ‘No, not really,’ then the IRS may argue you should not take the loss” and deny your attempt to harvest a loss.
For example, let’s say you buy Bitcoin for $60,000, Beecy said. At the end of the year you sell it for $40,000, absorbing a $20,000 loss. But then, immediately afterward, you buy more Bitcoin for $40,000. You may not think that would be considered a wash sale, because Bitcoin is not a stock or a security. But the IRS may look at the situation differently, asking if you truly suffered a $20,000 loss, or whether you’re in the same position you were in an hour ago, casting doubt on whether or not you’ve suffered a true economic loss. If the latter is the case, the IRS may challenge your claiming a loss and likely win based on case law precedent, Beecy said.
“If it’s just a tax loss and no economic loss, then you probably can’t take the loss,” he said. An economic loss would require a real loss of money, not just one on paper.
The Safest Strategy
The safest strategy may be to stay conservative with your tax and trading strategies, especially given the recent signals on cryptocurrency from the Treasury and the IRS.
“To be safe, you could sell the Bitcoin you bought at $60,000 on May 1 and then sold on May 20 for $35,000, for a loss of $25,000—you would not have a $25,000 tax loss asset to offset capital gains or income,” said Pat Larsen, chief executive officer of crypto tax software company ZenLedger, in an email. “You would then want to wait 30 days from when you sold your Bitcoin to buy it back if you wanted to be very conservative with your tax and trading. However, you could use the $35,000 proceeds from the May 20 sale to buy any other crypto, stablecoin, or publicly traded stocks.“
That would ensure you would clear the wash-sale rule and be able to harvest the remainder of the $25,000 loss to use against future tax liabilities, Larsen said, noting that only losses up to $3,000 annually can be subtracted in income tax.
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