More On: Bitcoin
If you follow the IRS guidelines and act quickly, you may be able to gain a tax benefit that will help you for years to come.
Bitcoin and other digital asset investors have just been battered by the longest losing streak since 2011. If that describes you, you'll be relieved to learn that there are strategies to lessen the pain of such losses: If you act quickly, you may be able to reduce your tax payment for next April and beyond.
Losses in stocks and other assets, including cryptocurrency, can be used to offset profits, according to the Internal Revenue Service. If your losses for the year exceed your overall gains, you can deduct up to $3,000 from your taxable income. Losses in excess of $3,000 can be carried forward year after year until death to offset gains in subsequent years.
The catch is that you have to sell the investment in order to absorb the capital loss; it can't simply have lost value on paper. Crypto investors, on the other hand, get a special deal. Stock owners must follow the wash-sale rule, which states that if they sell a stock for a loss, they must wait 30 days before buying the identical investment again, or the loss will be deducted.
The IRS has yet to say whether or not the wash-sale regulation applies to digital assets. (A provision in the Build Back Better Act was included that would have rendered crypto investments subject to the rule, but it was never implemented.)
That means you can sell cryptocurrency that has lost value since you purchased it, lock in the loss, and then quickly buy it back. The move has its limitations: the IRS is well aware that crypto investors have been doing so for years and may be searching for a way to retrieve some of their profits. According to Matt Metras, an accountant in Rochester, New York, who represents people before the IRS, the agency could turn to another section of the tax code that requires transactions to have "economic substance" in order to be eligible for tax benefits. To put it another way, you must take some market risk before repurchasing the same coin.
The major question is how long you should wait before repurchasing in order to keep your deduction. The most prudent method is to wait 30 days before repurchasing, just as you would with equities. However, considering how volatile the crypto market is, most accountants I spoke with thought that you could make a pretty persuasive case in a shorter amount of time that you exposed yourself to market risk.
Nobody knows how much shorter it will be. Since 2019, the IRS has not issued any detailed crypto guidance. Whether you wait 20 minutes or 20 days is entirely dependent on your risk tolerance: Is the possible tax savings worth the agony and scrutiny of an audit?
Separately, there has been some discussion recently regarding getting a full write-off for losses on coins that have been utterly devastated, such as Luna, which would allow you to deduct the entire amount of losses from your taxable income without being subject to the $3,000 yearly cap.
For the most part, this is a no-no. To qualify for a complete investment write-off from the IRS, the currency must be truly worthless. Even if Luna is no longer valuable, it is still worth something. And because its designer has offered a resuscitation plan, it's feasible that it will gain in value in the future. Furthermore, in order to get the entire write-off, you must completely dispose of the asset – you would have to send it to a burn wallet (which removes the coin from circulation).
For full-time traders, there is a way around the $3,000 cap as long as they follow specific guidelines. If you meet the requirements for "tax trader status" and make a special election, you will be able to register gains or losses at the end of the year without having to sell anything. Losses are fully deductible from taxable income. However, regardless of how long you've kept them, any gains will be taxed as short-term gains. According to Sharon Yip, a certified public accountant in Reston, Virginia, this implies they will be subject to ordinary income tax rates, which are higher than long-term capital gains rates.
If you're thinking about selling your crypto for a loss, make sure you know how long you've had it – anything less than a year is considered a short-term capital loss. Short-term losses will be employed first, followed by long-term gains, to offset short-term gains (and vice versa, with long-term losses offsetting long-term gains first before being applied to short-term ones).
Is it necessary to emphasize that the threat of paying higher rates for short-term gains should never force you to keep a crypto investment for longer than you want? Colby Cross, a Seattle accountant, says he had one client who made a huge profit on Filecoin in less than a year, but was concerned about having to pay extra taxes if she sold it. If you believe your currency is trading at an all-time high, don't try to save a few dollars on taxes, says Cross, especially given how quickly crypto markets may reverse.
Finally, some bad news: If you were defrauded by a crypto scheme, you will no longer be eligible for a tax credit as a result of changes made under the 2017 tax overhaul. Many scam victims were able to write off their losses prior to the law. They will now be responsible for those losses without the benefit of a tax write-off to cushion the shock.
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