If your cryptocurrency’s value has decreased, you may be able to lessen your tax bill by taking advantage of tax-loss harvesting.
This guide provides an overview of tax loss harvesting, explains why cryptocurrency is an effective candidate for this strategy, and outlines a step-by-step process for identifying the best candidates for tax savings in your crypto portfolio.
What is tax-loss harvesting?
If you earn a profit from selling your stocks, real estate, or cryptocurrencies, you will be required to pay capital gains tax based on the amount of money you made from the sale.
Some investors choose to reduce their capital gains taxes by selling some assets at a loss. This is called tax-loss harvesting.
TLH is a strategy to lower taxes by selling an investment at a loss to offset taxes owed on an investment sold at a profit or taxes owed on personal income. An investment can be anything that is traded, including stocks, bonds, shares in an exchange-traded fund, or even cryptocurrencies. Only investment accounts that are subject to taxes can utilize tax-loss harvesting, which only delays taxes, rather than cancelling them.
Advocates and critics of tax-loss harvesting agree that it is only appropriate for certain taxpayers in certain scenarios. Both groups also agree that all taxpayers should consult an investment tax professional before attempting tax-loss harvesting.
Advocates of the technique see it as a way to protect against market downturns, turning a negative into a positive. Although tax-loss harvesting can be beneficial, some experts warn that it can be difficult to do correctly and may have negative results even for experienced investors.
Capital Losses to Offset Capital Gains and Personal Income
The amount of money a taxpayer earns from selling an investment minus the amount they paid for it. An example of this would be if an investor sold stock that they bought for $25,000 for $27,000, they would have made a $2,000 profit. This profit would be taxed in the year that the stock was sold.
The IRS-approved strategy of tax-loss harvesting can be used in this situation. The investor could sell one of their other investments at a loss to deliberately offset the capital gain of $2,000 on their tax return. An example of this would be if an investor had another stock that they bought for $30,000 and then sold for $25,000 when the price dropped. In this case, the investor could “harvest” the $5,000 price difference as a capital loss. For tax purposes, a capital loss is not considered realized until the investment has sold for a price lower than the cost basis.
(Bloomberg.com) You can use capital losses to offset capital gains, which can lower your taxes. If you have more losses than gains in a year, you can use the losses to offset other income, or carry the losses over to future years.
Despite the fact that tax-loss harvesting can be done throughout the year, most people choose to do it at the end of the year when they are preparing to pay their annual income taxes. The deadline to take capital losses to offset capital gains for the year is December 31, so there is some urgency involved. However, if you wait until the end of the year to do all your tax-loss harvesting, you might miss out on some losses that are available early in the year.
Tax-Loss Harvesting Only Postpones Tax Obligations
Tax-loss harvesting is a technique that is used to lower the amount of taxes that an investor owes on their taxable investment account. It is important to keep in mind that the benefit of tax-loss harvesting is not that the tax obligation is completely cancelled. The benefit of a tax-deferred account is that the tax obligation is postponed. The reason tax-loss harvesting exists is because investors can save money on taxes by deferring them. The idea is that the money saved can be used to grow the portfolio now, and it is assumed that the amount of money made over time will be much more than the taxes that will eventually have to be paid.
When Tax-Loss Harvesting Works
The reason for pushing back the tax is that a dollar today is worth more than a dollar in the future—especially if the money saved on taxes this year is wisely reinvested and builds more wealth than the amount of any future tax bill at liquidation. Tax-loss harvesting can help grow a portfolio even if the taxpayer stops making contributions, as long as the reinvested tax savings are reinvested.
Both advocates and critics agree that tax-loss harvesting is appropriate only for certain taxpayers in certain scenarios, as mentioned above. If you have a taxable investment account and your taxable income is over the limits set by the tax code, you may be eligible for the general guidelines as long as you are planning to invest for a long period of time.
In all cases, it is significant to recall that tax-loss harvesting does not forever do away with the duty to pay taxes on capital gains—it only puts it off. If you liquidate your taxable account, you will have to pay taxes on any capital gains you have made at the tax rate that applies on the date that you liquidate.
Fintech Cuts Transaction and Administrative Costs
The costs of trade execution and regulatory filings are incurred whenever trades are executed, including when tax-loss harvesting trades are made. Critics of the widespread implementation of tax-loss harvesting have argued that the TLH is appropriate only for larger accounts, where the costs are a smaller percentage drag on the portfolio.
A 2020 study conducted by the MIT Laboratory for Financial Engineering found that recent advances in financial technology (fintech) and the overall decline in computing costs have lowered (or even eliminated) the transaction and administrative costs that often used to wipe out the benefits of tax-loss harvesting for small investors.
The article argues that fintech has made tax-loss harvesting more practical for small investors and that it has the potential to grow in the same way that index funds and the options market have.
When Tax-Loss Harvesting Doesn’t Work
Critics argue that pro-TLH theories make unrealistic assumptions about factors that are highly unpredictable in the real world. This means that, in order to benefit from postponing tax payments, both the tax rate for capital gains and the individual taxpayer’s tax rate would have to stay the same (or decrease). However, tax rates can never be predicted, so this is not a viable strategy. If tax-loss harvesting backfires, the taxpayer could end up owing a lot more in taxes than they saved by reinvesting their tax savings.
Some people disagree with tax-loss harvesting because they think it’s not beneficial for small investors since they don’t usually have large capital gains. This means that capital losses would just keep piling up without actually reducing taxes. The study found that 40% of how profitable TLH is to small investors is driven by factors that they can’t control and the remaining 60% is driven by individual investor profiles.
According to the analysts conducting the study, it is advisable to approach tax-loss harvesting on a case-by-case basis, especially for less experienced investors. The amount of tax-loss harvesting that should be done should be based on individual tax and income profiles, in the same way that investment advisors base asset allocation and risk profiles on each investor’s investment objectives and time horizons.
Tax-loss harvesting with cryptocurrencies
Cryptocurrencies can be used for tax-loss harvesting, just like stocks. This means that you can also sell or trade cryptocurrency to take advantage of losses and reduce your tax liability.
Stocks are often seen as good candidates for tax-loss harvesting, but cryptocurrencies have even better characteristics for this purpose. Let’s go through some of these advantages.
Does the wash sale rule apply to cryptocurrency?
The IRS has a “wash rule” in place to prevent investors from taking capital losses and then immediately buying the same stock again. You cannot sell a stock and then buy it back within 30 days if you want to avoid taking a capital loss.
Wash sale rules only apply to securities according to the IRS. According to IRS guidance, cryptocurrencies are property, not securities. This means that as of now, wash sales rules do not apply to cryptocurrencies. However, this could change in the future.
Volatility and tax loss harvesting
Cryptocurrencies are extremely volatile—more so than traditional assets. This means that crypto investors have more opportunities to make money by selling assets when they have decreased in value.
The most difficult part for investors is trying to figure out which cryptocurrencies in their portfolio cost the most when comparing it to the current market price. The following assets offer the best opportunity for saving on taxes.
Is there a limit to tax-loss harvesting?
If the total capital gains for the year are negative, then a net capital loss has been incurred. This means that if you have a net capital loss of $3,000 or less, you can use that loss to offset other types of income, like income from your job.
Losses that exceed $3,000 carry over to the following year.
How often should I harvest my losses?
At the end of the tax year, investors look for opportunities to minimize their capital gains through tax-loss harvesting.
This strategy is not ideal.
investors of cryptocurrencies have multiple opportunities to take advantage of tax-loss harvesting because cryptocurrencies are so volatile. Investors can save money by regularly taking advantage of price dips. This can also reduce stress at the end of a tax year.
What are the risks of tax-loss harvesting?
If you do not find yourself in one of these scenarios, tax-loss harvesting may be right for you.
- You are planning to liquidate your holdings soon: Be cautious of tax-loss harvesting if you are planning to sell off cryptocurrency you’ve purchased within the past 12 months. If you do sell your tokens, you will need to pay the short-term capital gains rate (10-37%) rather than paying the long-term capital gains rate (0-20%), which may apply if you’ve held your tokens for longer than 12 months.
- Your tax savings do not cover exchange fees: Before pursuing a tax-loss harvesting strategy, it’s important to consider exchange fees. It’s possible that the price to sell and rebuy your tokens is higher than your potential tax savings.
- Your long-term capital gains are already 0: If you’re single and making under $40,000 or married and making under $80,000, your long-term capital gains tax rate is already 0%. While tax-loss harvesting will not reduce your long-term capital gains tax, it can still offset your short-term gains and up to $3000 of income.
Can I do tax-loss harvesting with NFTs?
At the moment, NFTs are considered a type of crypto-asset, and are generally taxed under the same rules as cryptocurrencies.
Losing money on an NFT sale is similar to losing money on a cryptocurrency sale. It’s safe to say that the “wash sale” rule doesn’t apply to non-fungible tokens at this time.
CoinLedger can help you find opportunities to reduce your taxes by selling NFTs. Just type in your Ethereum wallet address and the platform will automatically handle the transaction.
How can I get started with tax-loss harvesting?
If you have several wallets and exchanges, it may be tough to keep track of the cost basis for each of your assets. This can make it difficult to identify opportunities for tax-loss harvesting.
CoinLedger can help. The platform enables you to quickly find all your tax-loss harvesting opportunities.
Let’s walk through the process.
- Connect wallets and exchanges: Import your transactions from exchanges and wallets automatically or through a spreadsheet.
- Generate your tax report: Once you’ve recorded all of your transactions, you’ll be able to generate a tax report with the click of a button.
- Navigate to the tax-loss harvesting tab: Here, you’ll be able to see all your tax-loss harvesting opportunities. The list is sorted by how large your opportunity is. The report compares your cost basis for tax-loss harvesting with the current market price.
See how much tax-loss harvesting reduces your tax bill.
After you have figured out which cryptocurrencies offer the best tax benefits, you can buy or sell them on your chosen exchange.
Identify which transactions you would like to import into CoinLedger and then run your tax reports again. After you lose a crop, you can see how much it decreased your net earnings.
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