Tax Management in the Virtual World
Recently we have seen how cryptocurrency investments can be very unpredictable. In November 2021, the cryptocurrency market peaked at about $3 trillion. Two months later, the cryptocurrency market plummeted over 40%, wiping out more than $1.2 trillion in a matter of months. This can be daunting to navigate, but just like any bear or bull cycle in the stock market, it can present opportunities to use different tax strategies.
Harvesting Losses and Wash Sale Rules
Plunging cryptocurrency investments can offer opportunities to harvest losses and offset some taxable income.
Currently, government bodies like the IRS have defined cryptocurrency as property, therefore it is possible wash sale rules may not apply to cryptocurrency.
This suggests taxpayers wanting to harvest tax losses from the drops in the cryptocurrency market may be able to do so without having to comply with the 30-day wash sale period. The wash-sale rule prevents you from selling a stock at a loss and rebuying it immediately for tax-loss harvesting purposes. If you trigger the wash-sale rule, your losses are tacked onto the cost basis of the rebought stocks.
Example of Wash Sale Rules:
Gary purchases 50 shares in Widget, Inc. on May 1, 2022, for $10,000. On May 15 he sells the shares for $8,000, realizing a loss of $2,000. Five days later he buys another 100 shares of Widget, Inc. for $7,500. Because the new stocks were purchased prior to the end of the 30-day period, Gary may not deduct a $2,000 loss. Rather, the basis in the newly acquired stock is increased to $9,500 ($7,500 purchase price + $2,000 loss). This results in Gary not benefiting from the loss incurred in selling his initial shares until the newly purchased stock is sold.
Because the wash sale rules do not currently apply to cryptocurrency transactions, cryptocurrency owners can sell their cryptocurrency at a loss, lock in the loss amount to apply against the taxpayer’s other capital gain, and then turn around and purchase the same cryptocurrency at the reduced rate, without having to wait 30 days to do so.
Wash Sale Rule Suggestions
President Biden and certain legislators have proposed expanding the wash sale rules to apply to cryptocurrency transactions. As originally sought in Biden’s Build Back Better Act, this would go into effect starting in the 2022 tax year.
Even if not subject to the wash sale rules, taxpayers may only deduct losses from sales of their cryptocurrency if they can show that these transactions had “economic substance” apart from the taxpayer’s desire to harvest the loss. To do this, the taxpayer must show that there was some economic risk involved before rebuying the same cryptocurrency.
Clearly, turning around and rebuying the same stock straightaway would not subject the taxpayer to much risk. However, given the enormous volatility in the crypto world in January 2021, and a $200 billion plunge in the cryptocurrency world in a single day in May 2022, a taxpayer can argue that waiting a few days prior to purchasing more cryptocurrency placed them at an “economic risk,” and therefore they should be able to harvest the loss.
If the loss is a capital loss, then only $3,000 of the capital losses may be utilized against the taxpayer’s ordinary income. However, unused capital losses may be carried over until used.
Essential to deciding whether a loss is a short-term or long-term capital loss is the cost-basis method selected by the taxpayer. If a taxpayer uses (FIFO) the first-in, first-out method, a long-term capital loss/gain will be generated if the taxpayer sells the cryptocurrency after a year. If the taxpayer uses a specific identification method, the taxpayer will have greater flexibility in generating a capital gain/loss.
The IRS FAQs state that a taxpayer may identify a specific unit of virtual currency either by documenting the specific unit’s unique digital identifier, such as a private key, public key, and address, or by records showing the transaction information for all units of a specific virtual currency, such as Bitcoin, held in a single account, wallet, or address. This information must show the following:
- The date and time each unit was acquired
- The basis and the fair market value of each unit at the time it was acquired
- The date and time each unit was sold, exchanged, or otherwise disposed of; and
- The fair market value of each unit when sold, exchanged, or disposed of, and the amount of money or the value of property received for each unit.
Traders in securities can make a mark-to-market election under IRC §475(c) to recognize gains and losses at the end of the year, even if they did not actually sell the securities. If the election is made, all losses and gains are treated as ordinary income/losses, denoting that all losses are deductible (not subject to the $3,000 capital loss limitation) and all gains are treated as short-term gains, meaning that they do not qualify for the capital gains tax rate.
A select group of tax professionals are of the opinion that active traders in cryptocurrencies will qualify for the mark-to-market election. Given that the IRS has declared that cryptocurrencies are property and not securities, we think it is best to wait and see if the IRS issues any guidance in this area before taking this position.
At this stage, crypto is a rapidly evolving field. Rules and definitions are always changing.
Please contact us if you have any questions.