A gaping hole in the tax code currently allows for a major tax-loss harvesting opportunity for cryptocurrency investors who are holding onto their crypto positions at a loss by allowing for wash sales (for now). But what does this all mean?
What is tax loss harvesting?
Tax-loss harvesting consists of strategically selling an investment at a loss, with the intention of using that capital loss to offset the amount of capital gains tax from the sale of other investments that resulted in a profit, in order to improve the after-tax return on taxable investments. Sophisticated investors often utilize this strategy to offset short-term capital gains, which are taxed as ordinary income, which is typically a higher tax rate than the long-term capital gains tax rate (37% for the top individual income tax bracket vs. 20% for the top capital gains tax bracket). https://www.nerdwallet.com/article/taxes/federal-income-tax-brackets;https://www.nerdwallet.com/article/taxes/capital-gains-tax-rates. Tax-loss harvesting can also be used to offset long term capital gains. https://www.investopedia.com/terms/t/taxgainlossharvesting.asp. Additionally, if an investor’s capital losses exceed your capital gains, the investor can lower their income by their total net loss for the year, up to $3,000. https://www.irs.gov/taxtopics/tc409. If the total net loss exceeds $3,000, the investor can carry forward the remaining net capital loss indefinitely to future years until the amount is exhausted. https://www.investopedia.com/terms/c/capital-loss-carryover.asp#:~:text=Capital%20losses%20that%20exceed%20capital,until%20the%20amount%20is%20exhausted.
What is a wash sale, and what is the wash-sale rule?
A wash sale occurs when an investor sells or trades a security at a loss, and within 30 days before or after the sale, the investor either buys the same or a substantially identical stock or security, or acquires an option to do so. https://www.investor.gov/introduction-investing/investing-basics/glossary/wash-sales. Also, If the investor’s spouse or a corporation that the investor controls buys the same or a substantially identical stock during that time period, that would also count as a wash sale. http://www.irs.gov/pub/irs-pdf/p550.pdf.
The wash-sale rule is an Internal Revenue Service regulation that prohibits an investor from taking a tax deduction for losses on a security sold in a wash sale. This rule exists to prevent taxpayers from claiming essentially artificial losses from selling securities when they are, in essence, maintaining their position in the securities. https://www.investopedia.com/terms/w/washsalerule.asp.
To illustrate this: Imagine an investor buys 10 shares of a stock on January 1 for $10,000. On March 1, the value of the position has decreased to $9,000, and the investor sells the 10 shares to realize a capital loss of $1,000 for tax purposes. On March 15, the investor purchases 10 shares of the same stock to re-establish their position. The $1,000 loss from the sale on March 1 will not be allowed to be used as a tax loss because the stock was repurchased within the wash-sale rule timeframe. What happens instead is that the loss amount is added to the cost of the March 15 purchase, and when the investor eventually sells the shares that they purchased on March 15, this adjusted cost basis will be used to calculate their eventual gain or loss. https://www.investopedia.com/terms/w/washsalerule.asp.
What is the loophole?
The loophole here is that the wash sale rule does not apply to cryptocurrency transactions. As stated above, in the wash-sale rule, the IRS prohibits an investor from taking a tax deduction for losses on a security sold in a wash sale. Currently, the IRS defines crypto assets as property, not securities. Therefore, the current wash sale rule does not technically apply to crypto assets, and crypto investors who are holding onto crypto assets with unrealized losses can take advantage of this and wash-sell them in order to offset capital gains and even up to $3,000 of ordinary income each year. Just like with tax-loss harvesting with more traditional assets, the investors can carry these losses forward to offset future gains. Where a stock investor would have to wait until day 31 to buy back into a stock position to avoid a wash sale, because the wash-sale rule does not apply to these crypto transactions, a crypto investor could theoretically sell their position at a loss and buy back in only seconds later, and the loss would be able to be used for tax purposes. https://tokentax.co/blog/wash-sale-trading-in-crypto. With the crypto market capitalization down 70% from it’s peak and 98.5% of all cryptocurrencies down more than 90% from their individual peaks, there are theoretically a very high percentage of crypto investors that can take advantage of this loophole. https://cryptobriefing.com/almost-every-crypto-asset-is-down-over-90-from-peak/.
Is the government aware of this loophole and do they plan on changing the rule?
In short, yes. The regulatory landscape for the fledgling crypto market is frequently changing, and it is possible that, any day, the wash sale rule could be expanded to start including crypto and/or other types of property. https://tokentax.co/blog/wash-sale-trading-in-crypto#references. In 2021, the Biden administration tried to pass the Build Back Better bill, which included language that would have expanded the wash sale rules to apply to crypto assets. https://rules.house.gov/bill/117/hr-5376. This bill stalled in the Senate and will most likely never be passed, but considering the fact that subjecting crypto to wash sale rules would raise an estimated $16.8 billion over the next decade (according to estimates from the Joint Committee on Taxation), it would not be difficult to imagine the government trying to get this rule change passed again soon. https://www.jct.gov/publications/2021/jcx-42-21/.
Another possible loophole
Even if the wash-sale rule does wind up getting expanded to include crypto assets, there may still be other ways to get around it for investors to continue harvesting tax losses on crypto. For example, to avoid a wash sale, a crypto investor could exchange their depreciated crypto holding for a different crypto holding that is closely correlated. After holding that correlated crypto asset for 31 days, the investor could exchange back into the original crypto asset. Cryptocurrencies are dissimilar enough that selling one and then buying another likely won’t violate the wash sale rules. https://www.cnbc.com/2021/09/14/house-democrats-plan-would-close-tax-loophole-used-by-crypto-investors-.html.
To illustrate: Uniswap token is an Ethereum-based DeFi token, and DeFi Pulse Index Coin is pegged to 10 top-performing Ethereum De-Fi tokens, so the two tokens are closely correlated (approximately 89% correlated over the past year). So, an investor could sell their Uniswap token at a loss, purchase the same amount of DeFi Pulse Index Coin, and then in 31 days, exchange back into the Uniswap token. https://tokentax.co/blog/wash-sale-trading-in-crypto.
The wash-sale rule could expand at any time to include crypto assets, but as it stands right now, this loophole exists and can be taken advantage of by many cryptocurrency investors.
Alex Woodin is an Associate Editor on the Michigan Technology Law Review.