Crypto Tax-Loss Harvesting: The Expert Guide for US Investors
With the tax deadline looming, tax loss harvesting can be a valuable strategy for US investors looking to minimize their tax liability when investing in cryptocurrencies and other digital assets.
Last Updated: May 11, 2023
What is Crypto Tax-Loss Harvesting?
Tax loss harvesting involves selling investments that have decreased in value to offset the gains from investments whose value has increased. By doing this, you can reduce the taxes you owe on your overall investment portfolio.
Crypto investors also use tax-loss harvesting to reduce their taxable gains by selling crypto investments at a loss. These realized losses are then used to offset capital gains from profitable trades, lowering the total amount subject to capital gains tax.
While many HODLers may want to avoid selling positions, a good investment strategy always includes minimizing and deferring taxes by turning those investment losses into actual tax savings.
In addition, the strategy can also be used as a way to diversify an investor’s portfolio or hedge against market volatility. When done correctly, it can help investors maximize their profits and minimize their risk in the crypto market.
How Harvesting Your Crypto Losses Works
When you purchase any asset, you have an acquisition cost (cost basis) which is equal to the amount you paid for this asset (plus any brokerage costs or fees). As the market fluctuates, the value of your asset goes up or down, creating an unrealized (paper) gain or loss depending on the market’s direction.
For tax purposes, claiming a loss on an asset is only possible once you sell it or exchange it. If you hold an asset with unrealized capital losses during a market downturn, selling or exchanging it allows you to claim the loss. You may later buy back the same asset at the reduced price for HODLing.
The selling or swapping of the asset constitutes a taxable disposal, which means that you recognize your gain or loss for tax purposes. Since you had an unrealized loss, by selling, you can now claim the loss.
Elon buys 1 BTC at $55,000. The price of BTC is now at $20,000, meaning his 1 BTC has a $35,000 unrealized loss ($20,000 current price – $55,000 acquisition cost).
If Elon harvests his losses and sells his BTC at $20,000, he can claim this $35,000 loss and use it to offset any gains made elsewhere. This is a simplified example of how tax loss harvesting works. For more detailed examples of offsetting gains, income, and carrying losses, refer to the section below.
What are the Benefits of Harvesting your Tax Losses?
Offset Your Crypto Gains
So you sold your crypto at a loss, how does this help you? This helps because you can use these losses to your advantage.
Offset your short-term and long-term capital gains. Short-term capital losses are first netted against short-term capital gains. Long-term capital losses are netted against long-term gains. Net short-term gain or loss and net long-term gain or loss are added together. This means that your short-term losses can offset your long-term gains and vice versa.
If you have an overall capital loss, you can use up to $3,000 per year of these losses to offset ordinary income! This includes salaries and wages & active business taxable income. Any losses in excess of $3,000 in a year can be carried forward to future tax years indefinitely until used.
Offsetting Crypto Capital Gains and Income Example
Elon purchased 1 BTC at $3,000 in 2019 and sold it at $35,000 in 2022. His gain therefore is $32,000.
Elon also bought 1 BTC in November 2021 at $55,000. The price of BTC is now at $20,000. If Elon sells his BTC at $20,000, he can claim this $35,000 loss in his taxes.
His short-term losses are $35,000
His long-term gains are $32,000
Elon can combine his gains and losses to get to a net capital loss of $3,000, which he can use to offset his wages from his job. If Elon had not sold his BTC purchased in November 2021, he would have had to pay taxes on a $32,000 gain. Instead, he pays no tax after realizing his losses.
Loss Carry Over Example
Elon purchased 1 BTC at $3,000 in 2019 and sold it at $25,000 in 2022. His gain from the above is $22,000.
Elon also bought 1 BTC in November 2021 at $55,000. The price of BTC is now at $20,000,if Elon sells his BTC at $20,000, he can claim this $35,000 loss in his taxes.
His short-term losses are $35,000
His long-term gains are $22,000
Elon can combine his gains and losses to get to a net capital loss of $13,000, of which he can use $3,000 in the current year against other taxable income, and carry forward $10,000 to use against future capital gains
If Elon had not sold his BTC purchased in November 2021, he would have had to pay taxes on a $22,000 gain – instead he pays no tax, has a loss and has losses to carry forward and use against future gains.
Offset Capital Gains Elsewhere
What if you have a taxable brokerage account with other gains? You may have a mutual fund which will pay you capital gain distributions. These are taxable distributions as capital gains that you can offset by harvesting losses in other assets, such as crypto.
You can offset capital gains (and capital gain distributions from mutual funds) from any taxable account with other capital losses from crypto assets. So if one class of investment is outperforming the other, sell your losers, claim your losses and make your tax life more manageable.
FOMO When it Comes to Selling? – Additional Strategies
FOMO is a bad reason not to make a smart financial decision. Let’s go back to our examples with Elon. In example 2, if he had not sold his BTC, he would have paid tax on a $32,000 gain.
Depending on his tax bracket, this could be up to a 30% capital gains tax rate even if it’s a long-term gain (when you consider the 3.8% net investment income tax plus state taxes). What is worth more to you? 20% to 30% on $32,000 ($6,400 to $9,600) or making a trade, paying a few fees, and no longer paying the capital gains tax?
To solve the FOMO, here are two strategies you can use. You can
1) repurchase everything shortly after or
2) plan a smart low-risk rebalancing strategy. Let’s unpack both.
Buy Everything Back Shortly After – Wash Sale Rule Risk!
You may ask, can I sell everything and repurchase immediately? Yes and no….proceed at your own risk. In traditional finance, the Wash Sale Rule forbids traders from doing just that. It states that if you repurchase assets after selling at a loss, you cannot claim this loss, and you defer the loss until you sell this repurchased asset. However, as of today, this does not apply to crypto.
Low-risk Rebalancing Strategies
Harvesting losses brings opportunity, and it’s wise to think twice about piling straight back into the same asset, especially if it was sold for profit. Once you have realized losses, you can take stock, assess your options and plan an intelligent low-risk investment strategy.
Rebalance Your Portfolio
As asset prices fluctuate and markets change over time, you may not need to buy back the crypto you sold. Instead, take advantage of an opportunity to think of a better asset allocation.
Reinvesting a portion of those gains into other assets to diversify your risk is a good idea. While this isn’t tax loss harvesting, it’s part of a good investment strategy that can help your portfolio absorb some of the volatility.
Plan For Liquidity Needs
It’s essential to have cash available to pay taxes and also to take advantage of great dip-buying opportunities. So once you have sold any crypto at a loss, allocate part of this cash to sit on the sidelines.
Having no cash available to pay taxes or take advantage of great dip-buying opportunities is never good. Once you sell your losing cryptos, you can allocate part of this cash to sit on the sidelines. Sure, this money won’t grow 10x, but if you sold your losing assets in December 2021 when the markets started to dip and sat on cash, you would be in an excellent position as of June 2022 to buy back at much better prices.
Find Correlated Cryptos
Take advantage of crypto assets that correlate with their price movements. Sure, the crypto markets are first linked to the Nasdaq, and then to BTC, but beyond that, you can find similar coins with a more significant correlation in their price movements.
Find a Proxy For The Asset
Suppose you’re an investor who likes to have exposure to a particular area of crypto, such as gaming tokens or layer-2 blockchains. In that case, you can keep your exposure without leaving the market entirely by selling your crypto at a loss into a similar token in the same field. Whilst this keeps exposure, you must do your own research as the tokenomics between projects often differs.
Another option is to find companies heavily associated with the asset, such as Microstrategy (MSTR), Grayscale Bitcoin Trust (GBTC) or a mining company. Many other assets move with BTC, and buying into those would not impact your ability to deduct your loss.
If you sold your ETH, you could look into the Grayscale Ethereum Trust (ETHE). You get the point – find other ways to keep the same exposure. Once the SEC approves a Bitcoin ETF, that will also be an excellent way for many investors to get direct exposure to BTC.
Remember that it’s key to have a good investment strategy. This includes considering the tax implications and having a tax strategy. Don’t just invest without goals, as emotions will get in the way when it comes time to take action.
What Are The Risks of TLH?
While tax loss harvesting can be beneficial, there are certain associated risks that you should consider before implementing this strategy. Some things to be vigilant of are market fluctuations and changes in personal income or tax rates that can further affect the taxes owed on an asset in the future.
Additionally, there is the risk of incurring higher taxes in the future due to a lower cost basis. When the cost basis is lowered through tax-loss harvesting, capital gains will be higher due to the larger difference between the sale price and cost basis.
Finally, there is a risk of triggering the wash sale rule if the same or substantially similar security is purchased within 30 days of selling the security for a loss. Let’s review the wash sale rule.
The Wash Sale Rule and Crypto Explained
If we take a look at the Internal Revenue Code §1091 (which provides the law on wash sales), we see that this law applies specifically to “stocks or securities” and the IRS FAQs clearly state that cryptocurrencies are property.
This has created a tax loophole for crypto traders for the time being. However, this will most likely be closed in the near future. Legislation packages have already had a provision to close this loophole, and while this has yet to pass, it is just a matter of time as the IRS and Congress seek to stop this tax game.
While as of today this rule technically does not apply to crypto, if you want to be extra safe, you should rethink buying back the same assets within 30 days (or the 30 days prior to selling at a loss).
What About Short vs. Long-Term Gains?
Short-term gains refer to profits made when an asset is held for a year or less, while long-term gains refer to profits made when an asset is held for more than one year. The IRS requires that short-term losses are offset against short-term gains first and long-term losses against long-term gains first.
If any capital losses remain after this process has been completed, they can be used to offset capital gains of the other type. This means that investors should consider their holding periods before tax loss harvesting to make the most of these potential savings opportunities.
How to Start Tax Loss Harvesting?
The only tool you need to get started is a reliable portfolio tracker, so a great first step is to set up a free account with Accointing and connect your wallets. From here, Accointing will show you your unrealized gains and losses on each of your investments, helping you identify potential tax loss harvesting opportunities.
However, before you dive right into realizing losses, it’s crucial to understand the basic principles and how to use software that allows you to take advantage of these opportunities and generate more tax-efficient income. That’s where Accounting’s tax loss harvesting tool comes in.
How Accointing’s Tax Loss Harvesting Tool Can Help
Accointing’s tax-loss harvesting tool helps you harvest your losses as effectively and efficiently as possible. On the tools tax loss harvesting dashboard, you’ll see your investments grouped by the asset. They are further divided into each wallet holding that asset and then into ‘tax lots’ as shown in the example below.
These tax lots are determined by what disposal method you use (FIFO, HIFO etc.) and show the order in which they would be sold or disposed of. The tool displays each tax lot’s unrealized profit or loss, and if the unrealized gains are short or long-term. You will also be shown how long a tax lot has left before it becomes a long-term gain, making this a handy tool for planning future trades.
On top of this, one of the most important advantages this tool provides is the information provided in the far right column. This column displays the tax impact if you were to start realizing the gains or losses from this specific wallet on this particular asset. How does this help? You can determine the most tax-efficient coin to harvest losses on throughout your crypto portfolio.
Alternatively, if you want to harvest losses on a specific asset, let’s use Bitcoin for example; by using this tool, not only can you identify which wallet is the most tax efficient to sell from, but you can also see how much Bitcoin you need to sell before you start selling into profit.
How to Use Accointing’s TLH Tool?
Check out the video embedded below for a rundown of how the tax loss harvesting tool works.
Does Tax Loss Harvesting Work on My NFTs?
Yes, if you have NFTs that have decreased in value since you acquired them, you can sell them to realize a taxable loss. Likewise, you can also use a burn address and realize a loss in exchange for $0 proceeds. For more information on the taxation of NFTs head to our US Guide for NFT Taxes.
Which Disposal Method Is Best for Crypto Tax Loss Harvesting?
While investors need to understand the differences between each method (HIFO, FIFO, LIFO etc.), there is no concrete answer regarding which method is best for tax loss harvesting. This is because everyone’s tax position is different and specific methods may be better suited to your individual circumstance.
If you are still determining which disposal method is suitable for you, it is recommended that you consult with a qualified tax advisor before selecting one.
What If I Have both Unrealized Losses and Gains for a Single Crypto?
In this case, it’s crucial to document your tax lots accurately to ensure that you are reporting losses rather than gains. Accointing’s tax loss harvesting tool will show you how to harvest your losses on a single currency as effectively as possible.
Is There a Limit To How Much I Can Tax-Loss Harvest?
No, but there are limits on how many losses you can deduct from your taxes. For example, when filing your taxes, you can only deduct up to $3,000 of losses to offset any capital gains. Any amount higher than this threshold for the year cannot be deducted but may be carried forward to offset capital gains or income in future tax years.
Is Tax-Loss Harvesting Considered Tax Evasion?
No, tax loss harvesting is a perfectly legal way to reduce tax liability. However, the IRS looks closely at such crypto transactions to ensure they’re genuine losses and not simply a way to hide taxable income. To ensure compliance with IRS regulations, it is always best to consult a qualified professional before engaging in tax planning strategies.
Given the volatile nature of cryptocurrency, it’s critical to understand how tax loss harvesting works and how you can use it to benefit your portfolio from a tax standpoint.