Tax Loss Harvesting
By: Oscar Armas Luy
Tags: Investing, Finance, Cryptocurrency, Money, Taxes

Tax Loss Harvesting

and the Cryptocurrency Loophole

At the time of writing, savvy investors can reap significant tax savings by combining the well-established strategy of tax loss harvesting with a loophole in the tax code to indefinitely defer some of their taxes without changing the allocations of their cryptocurrency portfolios.

Photo by Karolina Grabowska from Pexels

A Primer on Tax Loss Harvesting

We typically discuss tax loss harvesting in the context of a taxable brokerage account holding some mix of stocks and other securities such as options or bonds. In most cases, investors owe capital gains taxes when they make a gain on an investment. As such, taxable brokerage accounts sometimes generate a tax liability for investors as a result of regular or planned transactions, such as regular rebalancing, used to preserve the strategic allocation of the portfolio. This is where tax loss harvesting comes in. Investors with a mix of winning and losing positions, positions that have appreciated in value and positions that have depreciated in value, can offset some or all of their tax liability on the portfolio by choosing to realize a loss on depreciated positions. In other words, investors can choose to take losses in some positions to offset the gains in others and thus reduce or eliminate the tax liability on said gains.

Strictly from a tax perspective, tax loss harvesting is a no-brainer. Why choose to pay taxes on gains that we can easily offset? As always, it’s important to look beyond the tax implications and consider the bigger picture. It may not make sense to sell depreciated positions in a portfolio. Despite the tax benefits we outlined, the investor may wish to hold on to depreciated positions in a portfolio if he/she believes that they will appreciate over the long term. Additionally, an investor may not wish to sell depreciated positions if doing so would impact their long-term strategic allocation. Given the fact that a portfolio’s strategic allocation should be a long-term decision based on the taxpayer’s risk tolerance, financial goals, and day-to-day needs, it is likely not advisable to change said strategic allocation solely for tax purposes.

Many have tried to overcome these concerns by selling depreciated positions at a loss and reaping the tax benefits while then immediately buying the same or similar positions back. The goal is to offset gains without impacting the makeup of the portfolio. Unfortunately, the IRS has caught on and curbed this practice by creating the Wash Sale Rule.

Wash Sale Rule

The Wash Sale Rule prohibits investors from deducting losses from a sale in which the investor acquires the same or similar stock or security within 30 days. Said differently, investors must not re-purchase the same losing position they sold within 30 days if they wish to deduct the losses and thus reap the benefits of tax loss harvesting. While the general rule is simple, there are a few important nuances.

Firstly, an investor could theoretically sell a depreciated position and repurchase the same position on the 31st day after the sale. This method does not reliably overcome the non-tax considerations of implementing this strategy because the stock or security in question may have changed prices over the 31 days. Done repeatedly, the potential missed gains from exiting a position in one-month increments are enough to defeat any type of strategic allocation decisions.

Secondly, the wash sale rule applies only to losses and not gains. If an investor sells a position at a gain and then immediately repurchases it, he or she will still owe tax on that gain. The 30-day window does not apply when there is a gain. Generally it doesn’t make sense to deliberately realize taxable gains. It is generally advisable to defer taxes as long as possible so that the investor can maximize their available cash and invest it to earn an appropriate return. There are cases in which deliberately realizing a gain in this manner does makes sense, for example when a taxpayer is in failing health or terminally ill, however these are rare enough that for most taxpayers the general advice to defer gains as long as possible applies.

Thirdly, the wash sale rules apply to “substantially identical securities.” This means that an investor need not purchase the same security within the 30-day window for it to be considered a wash sale. If an investor purchases a similar enough security, such as a different ETF tracking the same index as the original sale, it is likely the IRS will consider these securities to be substantially identical and disallow the recognition of the loss at the time of sale. Some investors have gotten around this provision by purchasing securities that they believe are not substantially identical but have a similar exposure. For example, the sale of a depreciated technology stock may be replaced with an ETF with broad exposure to the consumer technology industry. While this method generally avoids triggering a wash sale, it isn’t foolproof. Non-sophisticated or hands-off investors will have difficulty performing this strategy effectively as many popular investment products have exposure to several sectors or sub-sectors and thus will require substantial knowledge and research to understand. Moreover, investors may have trouble knowing reliably where the IRS has drawn or will draw the line on what constitutes substantially identical securities. As such, the taxpayer may find themselves subject to an adverse ruling in the future and thus subject to interest and penalties, defeating the purposes of any sort of tax savings.

The Wash Sale Rule Does Not Apply to (Most) Cryptocurrency

So far we’ve discussed why the Wash Sale Rule generally discourages selling depreciated securities strictly for tax reasons by forcing investors to consider the overall non-tax implications on their portfolios. There is, however, a key loophole investors can take advantage of: cryptocurrency is not subject to the Wash Sale Rule.

The Wash Sale Rule applies to “stock or securities” (including option contracts). Cryptocurrencies are generally considered property by the IRS and not securities. Therefore, cryptocurrencies are not in scope of this provision. While this is true of most major cryptocurrencies such as Bitcoin or Ethereum used primarily as a method of exchange, it is likely that coins used in ICOs may be considered akin to a security or option contract by the IRS and therefore subject to these rules. Thus while not all cryptocurrency is exempt from these rules, the most popular are.

Thanks to this loophole, investors can indefinitely defer capital gains so long as they have commensurate cryptocurrency losses to offset their gains. Investors accomplish this by selling said cryptocurrency at a loss and immediately repurchasing it at the same price. Effectively, this transaction exists only in the eyes of the IRS as the investor has not made an economic transaction or suffered any change to their cryptocurrency portfolio except for any commissions or fees that may have been assessed on the trades.

Important Caveats Regarding the Cryptocurrency Loophole

Remember that this loophole generates a deferral as opposed to an avoidance of taxes. What this means is that even with this loophole an investor will eventually need to pay the full amount of the capital gains taxes at some point in the future. As we touched on earlier, a deferral is nothing to scoff at. Deferring taxes nearly always makes economic sense for the investor thanks to the time value of money.

It is also important to note that losses from cryptocurrency, or any investments for that matter, can primarily be used to offset other capital gains. A cryptocurrency loss can offset gains from the sale of other cryptocurrencies, stocks, securities, or assets such as a home or investment property. A cryptocurrency loss, or more generally a capital loss, cannot offset ordinary income, such as wages earned in a job or by a self employed taxpayer or contractor, beyond $3,000 in a given year. Even if a taxpayer faces significant capital losses, they can only offset a maximum of $3,000 in ordinary income in a given year. Any capital losses exceeding the $3,000 limit can be carried forward and used to first offset capital gains and then ordinary income up to the limit in future years indefinitely.

The limited track record and high volatility of cryptocurrency make it unsuitable for many investors. Cryptocurrency as an investment does not make sense under many strategic allocations, particularly for non-sophisticated investors. It is probably not advisable for investors to invest in cryptocurrency for tax benefits alone.

Congress and the IRS are continuously updating tax laws and the interpretation of tax laws. Investors that take advantage of this loophole should work with a tax professional or otherwise keep themselves informed of changes that limit or eliminate this loophole. While potential tax law changes are rarely a reason not to take advantage of a tax benefit today, it is important for taxpayers to adjust their tax planning strategies to remain compliant.

The Bottom Line

The Cryptocurrency Wash Sale Rule loophole is a powerful tax planning strategy for investors that allocate a portion of their portfolio to cryptocurrency. No single tax planning strategy or tax-consideration should be considered in isolation — taxpayers should consider the myriad of tax strategies and decisions regarding their investments in the context of their broader financial circumstances. It is likely that this loophole will only make sense for many taxpayers after they have exhausted more traditional means of mitigating their tax liability.