The crypto markets are in a bear market. There’s no way to sugarcoat the fact that crypto markets are having a difficult year. There is, however, a silver lining unique to crypto that tax-savvy investors can use to their advantage.
The term “bear market” is defined as a market that has lost more than 20% in a given year. Bitcoin is down -35% in 2022, ether is down -43% in 2022 and many other coins are down by much more.
Assuming an investor has lost money on a crypto position, there’s a unique opportunity to take advantage of these unrealized losses. Let’s walk through a scenario.
The wash-sale loophole and tax loss harvesting
Let’s assume an investor purchased $50,000 of bitcoin (BTC) and ether (ETH) in their crypto account and that the price of bitcoin was $55,000 per coin and ether was $3,500 per coin at the time of purchase. Assuming the investor split the funds evenly between bitcoin and ether at the time of purchase, he currently owns 0.45 BTC and 7.14 ETH. The investor held the coins through the bear market and still currently owns 0.45 BTC and 7.14 ETH. However, the current value of the position if bitcoin is trading at $29,000 and ether is trading at $1,900, is $26,616, an unrealized loss of $23,384.
In order to realize this loss, the investor can simply sell the crypto positions and the loss is realized. The -$23,384 loss can now be used to offset any taxable gains in other parts of the investor’s portfolio where he has profited. This is known as tax-loss harvesting.
In traditional financial markets an investor is forced to wait 30 days from the date of selling an asset in order to repurchase the same asset. If the investor does not wait 30 days, the transaction is considered a “wash sale” and the loss is not able to be used to offset a gain. So if you bought Tesla (TSLA) stock at $1,200 and sold it for $775 this year, you couldn’t rebuy Tesla stock for 30 days if you wanted to claim that loss of $425.
But this hasn’t (yet) been put into the tax code for cryptocurrency. So in the case above, if the investor still wishes to hold bitcoin and ether, he simply purchases the same amount of each immediately after selling the position. This does not create a wash sale, as it does in traditional financial securities.
The lack of a wash-sale rule in crypto is a very unique advantage to the savvy investor because crypto is incredibly volatile and its value may move significantly in 30 days. Being able to preserve a position while realizing the loss is a great way to boost long-term returns and increase tax efficiency of a financial plan.
While the market will certainly move some between a sell transaction and an immediate buy transaction, the investor in our example will be able to preserve most of his 0.45 BTC and 7.14 ETH position (minus market movement and transaction costs).
Crypto tax losses can offset more than crypto gains
Another thing to note: Losses realized in a crypto position can be used to offset tax liability on any gain realized, it does not have to be used against a crypto gain only.
It’s vital to note that taxation and crypto are a new frontier for many accountants and tax preparers. While the rules are clear, it’s incredibly important to track these transactions. If your crypto custodian does not generate a 1099 or if you self-custody your crypto, tracking your trades by hand or with the aid of crypto tax software is essential.
While we all wish crypto would simply rise in value forever, unfortunately that is not the case. Understanding the tax rules governing crypto positions can provide a unique opportunity during a bear market and can help ease taxable burdens of investors willing to do the work. While it is not guaranteed that this rule won’t change in the future, as of now this is a unique feature of crypto and should be used in financial planning.