Why tax season may be adding to the rout in Bitcoin, cryptocurrencies

Starting in 2022, the Internal Revenue Service (IRS) is expected to shut down a longtime tax loophole that allows cryptocurrency investors to harvest their losses to offset their tax burden. 

Digital coins, already under heavy selling pressure as the holidays approach, are getting hit by wealthy investors fearing a tighter tax regime next year. The shrinking loophole could be making matters worse.

Following a “relief rally” after the Federal Reserve’s policy decision, cryptocurrencies have been hammered along with stocks, as Omicron variant fears grip markets again. While short-term volatility has come to define crypto trading, year-end tax positioning may also be playing a role.

Buying high and selling low isn’t an ideal investing strategy, but with crypto there is a silver lining. Savvy investors can reap advantages on their tax returns by selling their crypto at a loss, then buying it back shortly thereafter. 

The “wash sale” rule is used to tax capital gains on stocks, bonds and other financial securities — but not cryptocurrencies. That loophole is one of several positions that might get closed by the Build Back Better bill pending in Congress. 

Jordan Bass, a certified public accountant (CPA) and tax lawyer, explained to Yahoo Finance the 30-day wash sale rule hasn’t ever applied to crypto assets that aren’t distinctly classified as securities. 

That has allowed savvy investors to sell their “underwater” positions, use the loss to offset income or other capital gains taxes, then buy back into the position at a lower cost basis within a short period of time.

For example, if an individual takes a $10,000 position in a crypto asset then the price of that crypto asset plummets by 75% to $2,500, that person can sell their asset at a loss of $7,500 — and use the loss to offset their total tax liability. 

Since the market for cryptocurrencies is very volatile, investors can quickly buy back into the coin of their choice at the $2,500 price at a more favorable tax rate, and occasionally recover their full position.

Once executed, they can use their capital loss to offset other gains or taxable income per year up to $3,000 according to the rules. The remainder can be carried forward for future taxable years indefinitely. For large investment portfolios, the outcome can make a staggering difference. The tactic is a well-worn strategy for billionaires

According to Bass, a number of his clients have harvested crypto losses for tax purposes, especially during the start of the asset class’ previous bear market in 2018.

“Investors can do that in crypto at least for the rest of the month. They can’t do that in the securities realm. Brokerage accounts track this information and report it in 1099s with adjustments based on the wash sale rule,” Bass explained.

The attorney also admitted harvesting tax losses is less ideal during booming times such as most of 2021, at least for “blue chip” crypto units like Bitcoin (BTC-USD) and Ethereum (ETH-USD). However, even those cryptocurrencies experienced major, albeit temporary, down swings through out the year.

The strategy proves especially useful for day traders who accumulate far more taxable events than a standard buy-and-hold investor. Bass admitted some clients newer to the cryptocurrency markets actually ended up owing more taxable income than the value of their total crypto holdings come tax day.

Just don’t try it with an NFT

Though investors can attempt tax loss harvesting all year long, it’s often considered and executed at the end of the year, according to Andrew Gordon, an attorney and CPA with Gordon Law. 

He told Yahoo Finance that a number of his firm’s clients have used the method this year, especially with their non-fungible token (NFT) holdings. And the method isn’t for the faint at heart, as many investors often miss or misunderstand the rules, Gordon explained.

The IRS’ “economic substance” doctrine explicitly prohibits a tax filer from reporting a loss that has no economic impact. That means investors can’t just sell their crypto, then buy it back at the same price and write it off as a loss. Also, they cannot do this with an NFT, whose selling point is its uniqueness (hence the ‘nonfungible’ in NFT).

“For Bitcoin or Ethereum which are fungible, it doesn’t matter which piece you have, it’s all the same. That’s not true for NFTs. You typically can’t sell and buy back the same one — and if you are, then, perhaps, the entire sale is a sham,” said Gordon.

“We’ve had people ‘sell’ to their friends then buy it back or they very immediately buy it back in the same instant,” Gordon said. “That’s not going to be accepted by the IRS.”

While the 30-day wash sale rule applies next year, Gordon pointed out that investors can always recognize losses from poor performing crypto assets, scams, or “rug pulls” since they hopefully won’t ever buy back those same assets. 

On the other hand, the opposite maneuver “gain tax harvesting,” often favored by high net worth investors, also contributes to selling pressure around crypto and other assets like stocks, according to Gordon.

He said many of his clients with substantial holdings are also selling their gains now before a tighter tax regime in the U.S. takes hold next year. 

David Hollerith covers cryptocurrency for Yahoo Finance. Follow him @dshollers.

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