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Crypto Tax Loss Harvesting: How It Works and Why It Matters

Crypto Tax

Crypto Tax Loss Harvesting:

Tax loss harvesting is a popular strategy used by investors to lower their tax bill by selling securities at a loss to offset capital gains. This technique can also be used with cryptocurrencies to realize crypto losses that can offset gains.

In this in-depth guide, we’ll cover everything you need to know about how crypto tax loss harvesting works, the rules and requirements, the potential benefits, and who can benefit from using this strategic tax move.

What is Tax Loss Harvesting for Crypto?

Cryptocurrency tax loss harvesting refers to the strategy of selling your digital currencies at a loss when the market value drops below your purchase price. This allows you to generate capital losses which can be used to offset capital gains realized when selling other cryptocurrencies at a profit.

Here is a formal definition of crypto tax loss harvesting:

Cryptocurrency tax loss harvesting is the strategic sale of crypto assets at a loss below the original cost basis to produce capital losses for the purpose of minimizing capital gains tax liabilities from profitable cryptocurrency sales. These generated losses are used to offset realized crypto capital gains.

This crypto tax strategy provides benefits by lowering an investor’s overall net capital gains that are exposed to capital gains taxes. This can reduce or even eliminate an individual’s tax burden from their profitable crypto transactions for the year.

The approach works the same way as tax-loss harvesting in stock investing and applies to cryptocurrency assets like Bitcoin, Ethereum, Solana, Cardano, and more.

Any cryptocurrency that is taxed by the IRS can qualify for crypto tax loss selling. This includes coins, tokens, stablecoins, DeFi governance tokens, and NFTs that meet the IRS classification guidelines.

How Does Crypto Tax Loss Harvesting Work?

Carrying out cryptocurrency tax loss harvesting involves several key steps:

  1. Track cost basis of crypto buys – Maintain detailed records of the cost basis for each lot of cryptocurrency you acquire. This includes purchase date, valuation in USD at time of buy, the amount of crypto coins/tokens purchased, and wallet addresses.
  2. Monitor portfolio for assets trading below cost – As market prices fluctuate, routinely check your portfolio for cryptocurrency positions with unrealized losses significant enough for tax loss harvesting.
  3. Execute trade to realize capital losses – Once ready to tax loss harvest, execute a sell transaction through an exchange or DeFi platform for the selected cryptocurrency trading below your cost basis to produce a realized capital loss.
  4. Wait 30 days to repurchase (optional) – To avoid violating IRS wash sale rules, wait at least 30 days before considering repurchasing the same crypto if you still want continued exposure in that asset after harvesting losses.
  5. Claim capital losses on taxes – The produced losses from the crypto tax harvesting trades can be claimed on IRS Form 8949 when filing your taxes to lower your net capital gains tax obligations.

Here is a simplified example to illustrate the crypto tax loss harvesting approach in action:

  • Lucy purchased 1 ETH at $4,000 in April
  • By December, 1 ETH trades at $1,200
  • Lucy tax loss harvests by selling 1 ETH to realize a $2,800 capital loss
  • She waits 31 days then repurchases 1 ETH if still interested
  • Lucy claims the $2,800 loss on her taxes to offset capital gains

As shown in this example, Lucy was able to lower her tax liability by intentionally selling Ethereum to generate a loss which offsets her taxable crypto income.

What Are the Rules and Requirements?

Conducting cryptocurrency tax loss harvesting properly requires paying close attention to associated IRS rules and requirements:

  • Trade crypto-to-crypto or crypto-to-fiat – Selling crypto for stablecoins or fiat cash produces losses just like trading crypto-to-crypto. Both qualify for tax loss harvesting treatment.
  • Avoid wash sales – The IRS prohibits claiming tax losses from wash sales which are trades made 30 days before or after a substantially identical purchase in the same crypto. You must wait more than 30 days before buying back the same coin you tax loss harvested if you want to benefit from the original realized losses per IRS regulations.
  • Track details of each trade – Closely monitor details like cryptocurrency valuations in USD on dates of acquisitions and disposals as well as wallet addresses to prove losses if ever audited and provide necessary documentation.

Proper documentation becomes very important for demonstrating to the IRS that realized losses were in fact genuine if your crypto tax return is ever challenged or audited.

What Are the Benefits of Crypto Tax Loss Harvesting?

Conducting purposeful crypto tax loss selling offers several advantages for cryptocurrency investors and traders including:

  • Lowers capital gains tax liability – The primary benefit is reducing your taxable income from cryptocurrency gains by balancing it with realized losses. This directly cuts your exposure to capital gains taxes.
  • Carry forward excess losses – If the produced losses exceed your crypto capital gains for the tax year, you can carry forward the remaining unused capital losses to apply in future tax years until the amount is completely offset.
  • Tax-savvy alternative to selling – For long-term crypto holders disinterested in selling their core positions, tax loss harvesting enables realizing losses for tax purposes without fully cashing out of the assets.
  • Hedges against future rate hikes – Locking in losses today could prove even more valuable in the future if capital gains tax rates increase later on. The Biden administration has specifically proposed hiking the highest capital gains rate from 20% to 39.6% for those earning over $1 million.
  • Take advantage of volatility – Cryptocurrency’s extreme cycles of booms and busts present prime opportunities to strategically harvest losses that may not exist with other assets like stocks.

The unique volatility of the crypto market compared to traditional assets gives investors an advantage in aggressively utilizing tax loss harvesting opportunities.

 

Crypto Tax

 

Crypto Tax Loss Harvesting Case Study

Consider the following scenario as an example case study for how crypto tax loss harvesting can play out in the real world:

Tom initially invested $10,000 into a portfolio of five different cryptocurrencies in January 2021 spread out as follows:

Date Crypto Quantity Cost Per Coin Total Cost
Jan 5, 2021 Bitcoin (BTC) 0.25 BTC $36,000 $9,000
Jan 10, 2021 Ethereum (ETH) 10 ETH $1,000 $10,000
Jan 15, 2021 Litecoin (LTC) 50 LTC $150 $7,500
Jan 20, 2021 Chainlink (LINK) 100 LINK $20 $2,000
Jan 25, 2021 Stellar (XLM) 5,000 XLM $0.30 $1,500

By December 2021, Tom’s crypto portfolio value sank significantly from the year’s highs, with losses across the board.

Tom decides to harvest his crypto tax losses before the end of the year by selling his losing positions to offset some capital gains he realized earlier from selling 1 BTC in February 2021 shortly after its peak above $50,000.

He initiates the following crypto tax loss sales on December 15, 2021:

  • Sell all 100 LINK at $15 per coin = $1,500 proceeds
  • Sell all 50 LTC at $100 per coin = $5,000 proceeds
  • Sell all 10 ETH at $3,500 per coin = $35,000 proceeds

Tom avoids selling his Bitcoin and Stellar to maintain his core holdings in those assets.

However, he does plan to wait at least 31 days before considering repurchasing the sold assets of LINK, LTC, and ETH.

By executing these tax loss harvest sales trades in December, Tom was able to realize a total of $20,000 in capital losses in 2021 as calculated below:

Crypto Cost Basis Sale Proceeds Realized Loss
100 LINK $2,000 $1,500 $500
50 LTC $7,500 $5,000 $2,500
10 ETH $10,000 $35,000 $17,000
Total $19,500 $41,500 $20,000

As a result, Tom can claim the full $20,000 capital loss amount on his 2021 taxes to offset his previous $15,000 gain from selling 1 BTC in February 2021 at a price of $55,000 when his cost basis was $9,000.

Harvesting these losses gave Tom peace of mind entering tax season knowing that he largely eliminated his 2021 crypto tax obligations and can carry forward the remaining unused $5,000 capital loss balance to apply in 2022 and beyond.

If the crypto market rebounds in early 2022, Tom also still has the option to rebuy the liquidated assets of LINK, LTC and ETH after waiting 31 days.

Common Concerns and Considerations

While crypto tax loss harvesting can produce substantial tax savings, some common concerns surrounding the strategy include:

  • Missing out on rebounds – It is impossible to time market bottoms perfectly so an asset sold may rebound soon after, leaving profits on the table. However, repurchasing after 31 days is an option.
  • High transaction fees – Trading fees charged on crypto loss harvest sales eat into realized savings. But for larger taxable amounts they are usually negligible relative to tax savings.
  • Complex tracking – Thorough record-keeping and tracking across exchanges, wallets, DeFi protocols, and chains is required to properly calculate and claim losses on taxes which can get complicated. Using crypto tax software can ease most of this burden.

As with any thoughtful tax planning strategy, the benefits of executing crypto tax loss harvesting judiciously will typically outweigh any associated hassles or expenses. But be sure to consider the pros and cons in your specific situation.

Conclusion: Who Can Benefit from Crypto Tax Loss Harvesting?

In summary, cryptocurrency traders and long-term HODLers with:

  • Taxable net gains – Realized gains from selling crypto assets at a profit that can be offset using harvested losses
  • Unused capital losses – Prior crypto losses carried forward from previous tax years

…are ideal candidates to benefit from proactively utilizing crypto tax loss harvesting now at year end or as a recurring tax reduction strategy.

Any crypto investor who finds themselves in a taxable net gain position can immediately lower their tax bill by intentionally realizing losses through crypto tax loss selling.

For instance, active crypto traders frequently cycling between trades can leverage periodic loss harvesting to minimize taxes owed. Even long-term buy-and-hold cryptocurrency investors holding assets acquired at lower cost basis can harvest sizable losses after large price declines.

Check your own crypto portfolio for tax loss harvesting opportunities before the end of the year. Selling losers at a loss while preserving your winners amplifies overall returns in the long run by letting you keep more profits in your pocket.

By understanding how to effectively conduct crypto tax loss harvesting and apply the harvested losses, individuals and businesses transacting in digital currencies can master this handy tool for reducing their cryptocurrency tax liabilities.

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