Tax-loss harvesting crypto in the US: The Guide for 2023

As a cryptocurrency investor, understanding the tax implications of your digital asset transactions is essential. In an evolving landscape, tax-loss harvesting is one strategy that can help manage your tax liabilities. This guide will delve into the concept of tax-loss harvesting, how it applies to crypto, and what you need to know to use this strategy effectively.

Key takeaways

• Crypto tax-loss harvesting allows investors to reduce their total tax liability.
• You can use capital losses to offset capital gains.
• You can deduct up to $3,000 of net capital loss per year to offset ordinary income.
• Any remaining losses can be carried forward into future tax years and be used to offset capital gains for each year and/or deduct up to $3,000 of ordinary income.
• There are different tax rates for long-term and short-term capital gains.

What is tax-loss harvesting?

Tax-loss harvesting is a strategy in which investors sell assets at a loss during market dips, usually at or near the end of tax year, to offset other capital gains, lowering their total tax liability​​. It allows you to use more of the money you currently have to grow your portfolio by postponing your tax obligations. While it doesn’t cancel any tax obligations, it gives your portfolio time to potentially generate significantly more than the tax amount you owe, resulting in a higher dollar amount in the long run​​.

Tax-loss harvest crypto

Tax-loss harvesting is applicable to cryptocurrencies, similar to other assets like mutual funds. Cryptocurrencies are considered property for tax purposes. Capital gains or losses are realized only when you sell, trade, or spend your crypto.

Crypto tax-loss harvesting deadline

It’s important to harvest your losses during the tax year as once the tax year is over, your gains and losses are locked in. Therefore, most people choose to harvest their losses at the end of the tax year. Harvesting losses becomes more common during market dips since reduced asset prices lead to greater losses, enabling a higher offset of gains.

Short vs. long term gains

Different crypto tax rates apply for long-term and short-term trades. Long-term capital gains are taxed at a more favorable lower rate in the US. Hence, if you possess unrealized losses, your tax advisor might recommend harvesting losses from short-term holdings rather than long-term holdings. This approach ensures that if prices rise later on, you can take advantage of the lower long-term capital gains tax rate when you sell the holdings for a profit.

To utilize this strategy, you may need to use a specific identification method rather than first-in-first-out (FIFO) as the cost basis allocation method because FIFO will most likely get you a long term loss.

Tax-loss harvesting limit

There are no restrictions on the extent of losses you can harvest, enabling you to draw a strategy to sell any desired number of assets at a loss. For instance, you have the option to sell assets to achieve zero capital gains or to sell a sufficient amount to result in an overall capital loss.

Nonetheless, in the event that your capital losses surpass your net capital gains, you have the ability to offset a maximum of $3,000 in capital losses against ordinary income. It is also worth noting that you can carry forward capital losses indefinitely.

We do not recommend over-using tax-loss harvesting because it is not a good idea to generate an excessive amount of capital losses that you cannot fully utilize for the current tax year. Each time when you sell an asset and buy it back later, you need to restart the holding period, which decreases your chance of having a long term holding period. You may end up having a short term, rather than long term, capital gain when the market price goes up later.

Tax-loss harvesting example

Let’s say you have $5,000 in capital gains for the tax year from various investments. Among your holdings is some Ethereum (ETH) that is currently worth $2,500 less than what you paid for it over a year ago. If you don’t take any action and don’t sell the ETH, you will have $5,000 of taxable gains for the year.

However, if you choose to harvest your losses and sell the ETH, you will realize a capital loss of $2,500. This loss can be used to offset your capital gains. As a result, you would only have $2,500 of capital gains that are subject to tax for that year​.

IRS wash sale rule

This rule prevents taxpayers from claiming a loss on the sale of an investment, then quickly buying the same or substantially the same investment back within 30 days before or after the sale. Currently, the wash sale rule applies to securities such as stock but crypto is not yet subject to the rule.This is a loophole that the U.S. government has been thinking about eliminating. If that happens, tax-loss harvesting for crypto will need to be planned and executed a lot more carefully than now.

Risks of crypto tax-loss harvesting

The strategic approach to offset capital gains and reduce overall tax liability can come with certain challenges. These can include complexities due to varying cost bases and holding periods for different cryptocurrencies, possible mismanagement of short-term vs. long-term holdings, challenges in estimating fair market values for non-fungible tokens (NFTs), and potential errors when dealing with unrealized gains and losses for a single cryptocurrency.

Lowering the cost basis

Engaging in tax-loss harvesting can be advantageous when selling a cryptocurrency at a loss. However, it’s important to consider that if you subsequently repurchase the same or a similar cryptocurrency at a reduced price, the cost basis for that cryptocurrency is adjusted downward. This implies that if the cryptocurrency appreciates in value and you decide to sell it in the future, you might be liable for even higher capital gains taxes due to the lowered cost basis. This may negate the tax saving from capital loss you generated from that crypto in an earlier year.

Crypto wash sales

At present, the wash sale rule, which specifically applies to securities, does not technically cover crypto assets. Nevertheless, there have been several proposed legislations seeking to prohibit wash sales involving cryptocurrencies. While none of these proposals have been enacted into law, it is important for investors to recognize that the matter is under consideration by legislative bodies.

NFT tax-loss harvesting

Although tax-loss harvesting for NFTs is feasible, similar to fungible tokens, it can present additional complexities. Challenges may arise when attempting to determine fair market values or encountering difficulties in realizing losses on NFTs that have become worthless.

Tips for tax-loss harvesting

To optimize your tax-loss strategy, it’s crucial to approach it correctly. Consider implementing the following fundamentals to maximize its effectiveness.

Optimal timing for selling

Make sure to harvest crypto losses before the end of the tax year. Once the tax year is over, your gains and losses are locked in. Most people elect to harvest their losses in the last month of the tax year while market dips are also popular times to harvest losses.

Investors aiming to maximize the benefits of crypto tax-loss harvesting capitalize on market volatility throughout the year. They strategically monitor unrealized losses and take advantage of buying opportunities during market dips. Utilizing tools such as CoinTracking, a crypto tax calculator and portfolio tracker, enables investors to track their tax liability and unrealized gains and losses. This empowers users to identify potential opportunities for tax loss harvesting throughout the tax year.

Frequency of tax-loss harvesting for crypto

There are no restrictions on the number of transactions and extent of losses you can harvest. This allows you the flexibility to either sell assets in a way that eliminates capital gains entirely or sell a sufficient amount to generate an overall capital loss.

Cost basis methods

Cost basis is used to determine the capital gain or loss on an investment, which is the difference between the selling price and the purchase price. Cost basis isn’t just the initial price of the investment, it can also include additional costs such as fees and commissions related to the purchase. The IRS allows several methods to calculate cost basis allocation method:

• First-In-First-Out (FIFO): This method assumes that the first shares bought are the first ones sold.
• Last-In-First-Out (LIFO): This method assumes that the last shares bought are the first ones sold.
• Highest-In-First-Out (HIFO): This method allows you to sell the assets that you paid the most for first.
• Specific Identification: This method allows you to choose specifically which shares to sell.

The method you choose can have a big impact on your tax liability, especially for investments like cryptocurrencies that can have highly variable prices. It’s always a good idea to consult with a tax advisor to determine the best approach for your specific situation.

It is vital to note that once you have chosen a cost basis method to calculate and report your capital gains and losses, you need to use the same method throughout the same tax year for each account. If you want to change the method after you filed your tax return, you will need to recompute your capital gains/losses for the year under a new permissible method, and file an amended tax return to report the updated result.

You are allowed to change your cost basis allocation method from one year to another. There is no requirement to file an application for change in accounting method if you want to use a method to file your current year tax return that is different from the method you used for previous year(s).

Reporting crypto capital losses

IRS crypto reporting involves various forms that may be required, depending on the nature of your crypto investments and transactions. These forms include:

• Form 1040: Serves as the main tax return form
• Form 8949: Used to report crypto capital gains and losses.
• Schedule D: Accompanies Form 8949 to summarize and calculate overall capital gains and losses.
• Schedule 1: Used to report crypto income, along with other types of income.
• Schedule C: Used to report self-employment income from crypto-related activities, such as mining or trading as a business.
• Schedule B: Used to report interest earned from crypto loans and stakings etc.

The specific forms required will depend on the type of crypto investments and transactions you have undertaken, as well as any applicable self-employment income.

Tax-loss harvesting crypto – a form of tax evasion?

Tax-loss harvesting is a legal strategy to reduce tax liability and is not considered tax evasion. However, it should be done carefully and in accordance with IRS rules.

Tax-loss harvesting in other countries

Canada

Capital losses from crypto are tax-free, allowing you to utilize them to reduce your tax bill. You can offset these losses against capital gains in the same tax year. The 50 % rule applies, enabling you to offset only half of your net capital loss in a year. Any remaining losses can be carried forward to offset future gains.

Australia

Capital losses can be deducted from capital gains and carried forward to future years. There is no time limit for carrying forward losses, but they must be used at the earliest opportunity. Losses can offset gains from various investments but cannot be deducted from other sources of income.

UK

Capital losses can be offset against capital gains to reduce tax liability. Registering these losses with HMRC allows you to offset them against future gains indefinitely. There is no limit on the size of losses that can be used for this purpose. It is important to register losses within four years to ensure they can be utilized for future offsets.

Conclusion

Tax-loss harvesting is a strategy to manage tax liability, but it requires knowledge of applicable regulations. CoinTracking offers automation for tracking prices, calculating gains and losses, and identifying assets suitable for tax-loss harvesting. It helps handle wash sale rules, differentiate short-term and long-term gains, and ensures correct harvesting of losses from specific tax lots. Utilizing such software simplifies tax filing by generating accurate tax reports based on transaction history.