Crypto tax planning can help optimize taxes by identifying opportunities to minimize tax liability on cryptocurrency transactions. For instance, donating cryptocurrency to a charitable organization can provide a tax deduction and also avoid capital gains tax on the donated assets.
Crypto tax-loss harvesting is another strategy that cryptocurrency investors use to reduce their overall tax liabilities. This article will discuss the concept of tax-loss harvesting strategy, how it works and the challenges involved.
What is crypto tax-loss harvesting?
Crypto-tax loss harvesting is a tax strategy that involves selling a cryptocurrency at a loss in order to offset any capital gains that may have been incurred from selling other cryptocurrencies at a profit. The idea is that by offsetting capital gains with capital losses, the overall tax liability is reduced.
Nonetheless, in order to claim a loss, the assets must be sold, and the proceeds must be used to purchase a similar asset within 30 days before or after the sale. This is known as the “wash sale” rule. Moreover, crypto tax-loss harvesting strategies can be used by individuals or businesses that have invested in multiple cryptocurrencies and are looking to minimize their tax burden.
Related: Cryptocurrency tax guide: A beginner’s guide to filing crypto taxes
However, in most countries, the losses can only be offset against capital gains and not against other types of income. Additionally, there are limits and restrictions on how much loss can be claimed and in which tax year it can be claimed.
In the United States, the Internal Revenue Service (IRS) has specific tax-loss harvesting rules including the wash sale rule, which prohibits an individual from claiming a loss on the sale of a security if they purchase the same security within 30 days before or after the sale. Additionally, the IRS limits the amount of capital losses that can be offset against ordinary income to $3,000 per year.
On the contrary, the United Kingdom does not have a specific wash sale rule for crypto investments, but there are general tax principles that may apply. For instance, the capital gains tax is applied to profits made from selling assets, including cryptocurrencies.
That said, if an individual sells a crypto asset at a loss, they can offset that loss against any capital gains they have made in the same tax year or carry it forward to offset against gains in future tax years.
However, if an individual repurchases the same or a similar crypto asset within a short period after selling it at a loss, this may be considered “bed and breakfasting,” and the loss may not be allowed as a deduction.
How does crypto tax-loss harvesting work?
Crypto tax-loss harvesting works by identifying a cryptocurrency whose value has decreased since it was purchased and then selling it at a loss to reduce the overall tax liability. To understand how to use tax-loss harvesting in crypto, the following steps may help:
- Identify cryptocurrencies whose price is declining: Look through your portfolio and identify any cryptocurrencies that have decreased in value since you bought them. This will be the cryptocurrency that you will sell to realize a capital loss.
- Determine the capital loss: Calculate the difference between the purchase price and the sale price of the cryptocurrency you identified in step 1. This will be your capital loss.
- Offset capital gains: Use the capital loss to offset any capital gains that have been made from selling other cryptocurrencies. This will reduce your overall tax liability.
- Timing: Timing is important in this strategy; you can offset capital gains from the same tax year or carry the losses forward to the next tax year.
- Keep records: Keep records of all the transactions related to the tax-loss harvesting strategy, as you will need to provide them to the tax authorities.
Risks of tax-loss harvesting in crypto
Tax-loss harvesting in crypto can be a useful strategy for reducing overall tax liabilities, but there are also several risks associated with it. Here are a few examples:
- Wash-sale rules: As noted earlier, in some countries, the tax code includes wash-sale rules that prohibit claiming losses on the sale of a security if a substantially identical security is purchased within 30 days before or after the sale. This can limit the ability to use tax-loss harvesting effectively.
- Short-term vs. long-term gains: In many countries, short-term capital gains, which are gains on assets held for less than a year, are taxed at a higher rate than long-term capital gains. If you engage in tax loss harvesting and buy back the same cryptocurrency within 30 days, you may end up with short-term capital gains, even if you originally held the asset for a longer period of time.
- Market fluctuations: Cryptocurrency prices are known to be highly volatile and can be affected by various market conditions, events and regulations. If the price of the cryptocurrency an individual sold at a loss increases shortly after the sale, they may have missed an opportunity to make a profit.
- Complexity: Tax laws related to cryptocurrency are still evolving and can be complex to understand. In the United States, for example, the Securities and Exchange Commission has issued guidance stating that some initial coin offerings (ICOs) may be considered securities and, therefore, subject to federal securities laws. Additionally, there are also state-level regulations that may apply, making it challenging for companies looking to conduct an ICO.
- Lack of knowledge: Not having enough knowledge of the crypto market and the specific tax laws and regulations in your country may lead to mistakes and potential penalties.
Considering the above risks, it is essential to weigh the potential benefits of tax-loss harvesting against the risks and consult with a tax professional before implementing this strategy.
How to reduce your crypto tax bill
There are several ways to reduce your crypto tax bill, as explained below:
- Tax-loss harvesting: As explained earlier, selling a cryptocurrency at a loss can be used to offset any capital gains that may have been incurred from selling other cryptocurrencies at a profit. This can be used as a tax strategy to lower the overall tax liability.
- Holding period: In many countries, short-term capital gains, which are gains on assets held for less than a year, are taxed at a higher rate than long-term capital gains. Holding your cryptocurrency for more than a year can result in lower taxes.
- Using tax-advantaged accounts: Some countries allow individuals to hold cryptocurrency in tax-advantaged accounts, such as a self-directed IRA or 401(k). This can provide significant tax benefits.
- Charitable donations: Donating cryptocurrency to a qualified charity can be tax-deductible and can also be a way to dispose of appreciated assets without incurring capital gains taxes.
- Tax deferral: Some countries allow individuals to defer paying taxes on crypto gains by rolling them over into a qualified opportunity fund (QOF) or a similar exchange. Any investment vehicle (other than QOF) that retains at least 90% of its assets in qualified opportunity zone property and is set up as a corporation or partnership for the purpose of investing in such property is referred to as a qualified opportunity fund.
While reducing one’s crypto tax bill is an important consideration, it shouldn’t be the sole focus when investing in crypto assets because tax laws related to cryptocurrencies are still evolving and can be complex to understand. Also, if someone engages in illegal activities, such as tax evasion or money laundering to reduce their crypto tax bill, it could lead to legal issues and severe penalties.
How to report crypto losses on your taxes
The process for reporting crypto losses on one’s taxes may vary depending on the country they live in, but here is a general overview of the steps one may find helpful:
- Keep detailed records of all your crypto transactions, including purchase and sale dates, prices, and amounts. This will be useful when calculating capital gains and losses.
- For each crypto transaction, calculate the difference between the purchase price and the sale price. If the sale price is lower than the purchase price, the difference is considered a loss.
- In most countries, users will need to report their cryptocurrency losses on their income tax return, while in some countries, they may need to file additional forms or schedules specifically for reporting crypto losses.
- If a user incurred more losses than gains, they can claim the losses on their tax return to offset any capital gains.
- Keep all documentation and records of your crypto transactions in case the tax authority requests them.
Regardless of the above steps, cryptocurrency tax professionals may help understand the process and requirements specific to one’s jurisdiction due to different tax regulations in various countries.