Source: TaxDAO
A wash sale occurs when someone ostensibly sells a cryptocurrency or security to incur a loss, and quickly re-purchases the same or similar cryptocurrency or security to obtain a tax benefit. Wash sale rules prohibit the sale of a security at a loss and the re-purchase of the security within 30 days to prevent taxpayers from lowering their tax liability through “artificial” losses.
For U.S. taxpayers, there are no cryptocurrency wash sale rules, so cryptocurrency wash sales are technically legal. However, we recommend avoiding wash sales of cryptocurrency, as lawmakers appear to be working to close this loophole.
What are cryptocurrency wash sale rules?
Tax-loss harvesting is a strategic tool used to minimize tax liability by selling investments that have unrealized losses. Through this approach, investors can realize capital losses, which can help offset capital gains on other investments or up to $3,000 of ordinary income per year.
A wash sale occurs when a holder sells a cryptocurrency or security at a loss and quickly re-purchases the same or similar cryptocurrency or security to incur a capital loss. If a U.S. cryptocurrency user buys back their crypto assets immediately after selling them, this is a cryptocurrency wash sale. The wash sale rule was created to prevent investors from incurring losses on assets they still hold. The simplest way to avoid the wash sale rule is to wait 30 days after selling an asset before buying it back. The problem with this is that prices can change in 30 days and the gains won't be the same.
The IRS uses the wash sale rule to discourage apparent securities trading. While the IRS has not clearly outlined the applicability of the rule to cryptocurrencies, the growing interest from regulators and lawmakers suggests that regulation may be tightened to address known loopholes. Conservative, risk-averse investors are therefore advised to avoid cryptocurrency wash sales.
How do the cryptocurrency wash sale rules work?
Losses incurred from wash sales of stock or securities are subject to the wash sale rule under 26 U.S.C. § 1091, meaning that if an investment you hold has lost value, you cannot repurchase it within 30 days of selling it to claim a loss. The rule prevents taxpayers from using "artificial" losses to offset their gains and reduce their capital gains tax liability.
The main thing about the wash sale rule is that if the investor repurchases a substantially identical security or crypto asset within 30 days of the sale, the capital loss is not allowed for tax purposes.
Here is an example of a wash sale rule for crypto:
On December 30, Aaron had a gain of $15,000 and a loss of $5,000, for a total gain of $10,000. He also holds 20 BNB with a cost basis of $10,000, but a current fair market value of $4,000.
Aaron sells the 20 BNB for $4,000, realizing a capital loss of $6,000.
On January 5, Aaron decides to buy 20 BNB for $4,200. This is within 30 days of the sale.
When it comes to paying taxes, Aaron reports a $6,000 loss on 20 BNBs in order to reduce his overall gain from $10,000 to $4,000. Due to the wash sale rules, his loss is disallowed for tax purposes. Therefore, he is required to pay taxes on the $10,000 gain.
Aaron’s cost basis in the new securities is adjusted to reflect the disallowed loss.
If he later decides to sell the new securities for a gain, the adjusted cost basis is used to calculate the taxable gain or loss.
How to Save Taxes with Crypto Wash Sale Rules
The IRS wash sale rules do not currently apply to cryptocurrencies because it deems virtual currencies to be property rather than securities. This effectively means that there are no cryptocurrency wash sale rules at the time of this writing. Technically, cryptocurrency wash sales are allowed. However, lawmakers and regulators say this may soon change.
In September 2021, a proposal from the House Ways and Means Committee included language that would apply the wash sale rules to digital assets, creating the cryptocurrency wash sale rule. These developments highlight the administration’s interest in the matter, despite the Build Back Better bill stalling in Congress.
Biden acknowledged in 2021 that the Build Back Better bill would not be passed by the end of the year, but he remained steadfast in his desire to pass it as soon as possible. In March 2022, President Biden signed the bill, calling on federal agencies to pay more attention to cryptocurrency wash sales. This series of events shows that federal agencies are moving quickly to change legislation regarding cryptocurrency wash sales.
How Does the Wash Sale Rule Affect My Tax Bill?
The purpose of a cryptocurrency wash sale is to minimize your tax liability by reducing your capital gains. By washing crypto, you can pay less tax. However, as mentioned above, this loophole can be closed, so we strongly recommend avoiding wash sales. There are safer strategies that effectively achieve the same goal:
By repurchasing the crypto asset after the 30-day period has passed, your actions will no longer be classified as a wash sale and will avoid any future cryptocurrency wash sale rules (assuming the rules are the same as the current rules for securities).
You could swap the depreciating asset for a token that is closely correlated to its price. You would hold that correlated token for more than 30 days and then repurchase the original asset.
Changes to the Wash Sale Rules and How They Impact Investors
If the cryptocurrency wash sale rules change, it could have a significant impact on cryptocurrency investors. Modifications to the rules would impact strategies that some investors use to manage their portfolios and minimize tax liabilities. If the wash sale rules are expanded to include cryptocurrencies, investors will need to reevaluate their trading behavior and consider waiting longer before repurchasing assets after a sale to avoid potential penalties. Regardless, we recommend avoiding cryptocurrency wash sales.
Changes to the wash sale rules could also increase scrutiny from tax authorities and regulators. Investors should stay up to date on any changes to the rules and proactively adjust their tax strategies.
How do I know which of my assets are currently losing money?
Determining which of your assets are currently losing money is an important aspect of effectively managing your cryptocurrency portfolio. To identify underperforming assets, you can regularly track the market value of each crypto asset based on its initial cost basis. Using specialized cryptocurrency tax software can simplify this process by providing a comprehensive overview of your portfolio's performance and identifying assets that are currently trading at a loss.
Regularly reviewing your portfolio and evaluating individual asset performance using tools such as Zerion can allow you to make informed decisions, such as tax losses or strategic asset reallocations. By remaining vigilant and utilizing the tools available to you, you can optimize your investment strategy and reduce potential losses in the dynamic and volatile cryptocurrency markets.
Is cryptocurrency wash trading legal?
Wash trading in the cryptocurrency market involves artificially inflating trading volume by executing buy and sell orders for the same asset with the intent of creating misleading market activity.
As of now, wash trading is generally frowned upon by regulators. However, the legality of wash trading in the cryptocurrency space can vary by jurisdiction. While wash trading is technically legal for U.S. cryptocurrency users, we advise against it as legislation could change this.
Crypto Wash Sale FAQs
Here are answers to some common questions about the cryptocurrency wash sale rules.
1. Is the cryptocurrency wash sale rule 30 days?
You cannot claim a capital loss on a security if you purchase the same asset within 30 days of the sale. Therefore, based on current IRS guidance, it is reasonable to assume that the wash sale rules do not apply to cryptocurrency.
2. Do the wash sale rules carry over to the next year?
Yes. If you sell an asset and reacquire it within 30 days, this is considered a cryptocurrency wash sale, regardless of whether the sale carries over to the next calendar year. So if you sell on December 15th and buy it back on January 1st, this is considered a wash sale.
3. Can you still wash sell with cryptocurrency?
Technically, yes, there are currently no cryptocurrency wash sale rules. However, the Biden administration has begun to investigate cryptocurrency cases more carefully, and the loopholes that currently allow cryptocurrency wash sales will likely be closed soon, making cryptocurrency wash sales illegal.
4. How do I know which of my assets are currently trading at a loss?
The only way for you to understand the performance of your overall portfolio is to track all cryptocurrency profits and losses.
5. The Future of Cryptocurrency Wash Sale Rules
Given recent developments in cryptocurrency regulations, including the signing of the "Build Back Better" Act, which will take effect in March 2022, changes to cryptocurrency wash sale rules can be reasonably expected. The legislation authorizes federal agencies to pay more attention to cryptocurrency wash sales, signaling a growing interest in the cryptocurrency space and a potential regulatory shift.
As the Biden administration expresses interest in crypto cases and investigations become more rigorous, the legal status of crypto wash sales may soon change. Therefore, it is recommended to proceed with caution. Stay tuned for updates and proactively adjust your strategy as the regulatory environment changes.
6. Can you sell cryptocurrency at a loss and then buy it back?
Yes, you can sell cryptocurrency at a loss and buy it back at any time. When a trader does this quickly in order to avoid a tax loss, the wash sale rules apply. For tax purposes, the safest approach is to wait 30 days from the date of the sale before buying back.
7. How to bypass the wash sale rules?
The easiest way to bypass the wash sale rules is to wait 30 days after selling an asset before buying it back. The IRS wash sale rules state that if a trader sells a security at a loss and then buys it back within 30 days, the initial loss cannot be claimed for tax purposes.
8. Are wash sales of losses not allowed in cryptocurrency?
As of the time of writing, there are no active cryptocurrency wash sale rules for U.S. taxpayers, and cryptocurrency wash sales are technically legal. However, this is expected to change as legislation is proposed.
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