Although the entire cryptocurrency market lost about $1.4 trillion in 2022, some investors could have used the dip to save big when they file their taxes through a strategy known as tax-loss harvesting, which can be useful to those who have assets that declined in value. It's too late to take advantage for the 2022 tax year, but it doesn't hurt to plan ahead for 2023.
To understand tax-loss harvesting, you first need to know how the Internal Revenue Service handles crypto gains and losses.
The IRS treats virtual currency as property. When you sell it at a loss, meaning you weren't able to recoup the amount you paid for it, the agency allows you to use those losses to offset profits made from other investments, known as capital gains. If capital losses exceed annual capital gains, investors can use the remainder to offset up to $3,000 from their regular income at tax time.
Capital gains are typically taxed at a lower rate than ordinary income, which includes what you earn at your job or from a side gig.
Keep in mind that capital gains can only be offset by the same type of loss. Long-term gains, which means you've held your crypto for longer than a year before selling, can only be reduced by long-term losses and short-term gains, which means you've sold your crypto before one year, are reduced by short-term losses.
Tax-loss harvesting is a strategy that uses these rules to your advantage — and crypto holders can utilize it in a way other investors can't.
What makes crypto different
Unlike stocks, the wash sale rule doesn't currently apply to crypto. This rule states that you aren't allowed to claim a tax deduction if you sell a security at a loss and replace it with the same or a "substantially identical" security 30 days before or after the sale, according to the IRS.
This means that, in theory, you could sell your crypto, claim the loss and buy it back without having to wait the usual 30 days.
However, be wary of using this loophole to abuse the tax system, says Shehan Chandrasekera, a certified public accountant and head of tax strategy at crypto tax software company CoinTracker.io.
If you're frequently selling crypto at a loss, then immediately buying the same digital coin, the IRS would disallow the tax benefit, Chandrasekera tells CNBC Make It.
"I would not advise anybody to do that. I would say just wait a reasonable period of time," he says. "Obviously, you don't have to wait for the 30 days, but again, wait a reasonable time before you buy back the same coin."
Some traders do this once a quarter, once a month or every other week, Chandrasekera says.
Tax loss harvesting can be used to eliminate or reduce taxable capital gains
If you want to move forward with harvesting your crypto losses, it's important to understand how it could impact your tax bill.
If you sell crypto that has risen in value and you've held for more than a year, the profit will be subject to capital gains tax. Although capital gains are taxed at lower rates than ordinary income, offsetting those gains with capital losses is even better, because it can reduce or eliminate the amount of tax you owe.
Say you bought crypto for $10,000 and later sold it for $13,000. You would face $3,000 of taxable capital gains. However, if you incurred $3,000 worth of losses on crypto transactions, you would be able to offset the tax you owe, Chandrasekera says.
And if you have $10,000 worth of capital losses in one year, but only $3,000 worth of capital gains, you can carry over the remaining $7,000 and use it to offset gains realized in the future, Chandrasekera says.
"You can carry it forward to future years indefinitely," he says. "In the second year, if you don't have a couple of gains to offset, that's fine. You can carry it forward until you die."
It's important to note that crypto tax loss harvesting requires careful tracking of how much you've paid and sold your crypto for. This can be difficult for some investors without the use of reputable software that can track your transactions for tax reporting purposes.
And remember, every investor's tax situation is unique. Talk to your tax advisor before making changes to your portfolio.
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