Crypto investment is a potentially lucrative and risky undertaking that can lead to thousands of dollars of gains or losses for individual investors. But how does trading on a crypto exchange affect your taxable income at the end of the year? Since the introduction of cryptocurrencies in 2009, “tax loss harvesting” has helped crypto traders avoid taxes by taking advantage of a capital loss.
How Do Capital Gains and Losses Work?
Most investors pay taxes on their regular income and any realized capital gains from their investments. However, if they realize losses in their investments, they can use those losses to reduce the value of their capital gains as well as offset a certain amount of their taxable income if their losses exceed their gains and they have a negative investment balance.
You can offset up to $3,000 of your taxable income with capital losses ($1,500 if married and filing separately). However, this doesn’t release you from your tax obligation.
The theory behind postponing your obligation is that you can reinvest those funds, earn more than the amount you owe, and earn more than if you didn’t claim your capital loss deduction.
Tax Loss Harvesting and Cryptocurrency
So how do crypto traders avoid taxes? They often sell in “wash trades” during crypto downturns or around the end of the year, then nearly immediately buy their coins back. These wash trades are illegal in most regulated markets. This crystallizes the trader’s losses to offset other investment gains and reduce their tax obligation, allowing them to get their coin back in “tax loss harvesting.”
According to the National Bureau of Economic Research, the Bitcoin crash in 2018 cost $16 billion in losses for the U.S. Treasury Department. Estimates from Barclays PLC indicate that crypto traders are avoiding up to $50 billion in taxes each year.
While many crypto investors can’t remain tax-free when filing their tax returns, they can diminish their owed taxes using tax loss harvesting. However, some investors who have turned crypto trading into a career and have no other source of income can manipulate their gains and losses to pay no taxes at all.
The Wash-Sale Rule
The IRS wash-sale rule prevents immediate buybacks of investment securities that resulted in a realized capital loss. There is a 61-day waiting period before an investor, their spouse, or a company owned or controlled by the investor or their spouse can purchase the same security.
What the IRS Is Doing About Loss Harvesting in Crypto Investment
The IRS now requires brokers to report cryptocurrency transactions over $10,000 to try to prevent non-reporting of income and earnings from crypto investments. This has led to an increase in tax loss harvesting by crypto investors.
Greater scrutiny by the IRS could lead to cryptocurrency traders moving to crypto exchanges based outside of the U.S. The IRS will need to coordinate with international financial departments to prevent U.S.-based traders from avoiding tax obligations by moving crypto assets overseas.
Contact Levy & Associates Tax Consultants for Questions About Cryptocurrencies and Taxes
Tax loss harvesting is how crypto traders avoid taxes, but understanding how losses can reduce your tax obligations legally for crypto, stocks, and other investments can benefit you. If you have questions about your investments and taxes, call us at Levy & Associates Tax Consultants at 800-TAX-LEVY (800-829-5389) or contact us online to speak with a tax professional at our offices in Lathrup Village, MI, or Delray Beach, FL.