Cryptocurrency Taxation: Crypto Tax Loophole Explained

Considering crypto’s vibrant blooming stage at present, it might come as a shock for many that in the not-too-distant past, these trending and most-used cryptocurrencies did experience a fall in their lowest prices of the year.

Where Bitcoin managed to hit its all-time high mark in May and then quickly faced a drop to lower levels, nearly all cryptocurrencies followed the suit. Just like anything else, this isn’t the first time it happened and most probably not the last.

Crypto Tax Loophole

This might come across as a distressing situation, especially for the investors speculating on crypto’s long-term appreciation, for the others, this situation could be a welcoming incident for opportunities. But, why?

A Quick Recap!

As we are aware, the IRS classifies these virtual currencies, also including Shiba Inu as a property. Meaning, the investors of crypto are liable to pay the crypto taxes on capital gains and losses, with one difference - escaping the “wash sale” rule.

This loophole of tax, which has a probability of closing by pending legislation, can help save crypto investors some money when it comes to paying the tax. Unlike those investing in securities, crypto investors are capable of taking full advantage of the rules of tax-loss harvesting without the virtual currency time-out purchase.

For example, if you hold crypto and want to use it as part of a tax-loss harvesting scheme, you'll need to know what's allowed and what's not. To help you get started, we've put together this post that delves deeper into tax-loss harvesting, wash sale restrictions, and how the present situation could evolve for crypto investors.

Wash Sale: Meaning and the Rule

The wash sale is experienced when you trade or sell a security at loss but then choose to purchase similar security in a short period of time. (Selling at loss entails the disposing of the asset at a fair market value below the original cost basis).

Wash sales are used by crypto investors to assist them to maximise their tax deductions after selling loss-making shares. The IRS established the wash sale rule in response to this strategy of "gaming the tax system."

The Rule

The wash sale rule prevents tax deductions of losses from the sale or any other disposition of securities or stock if you purchase the same asset within 30 days, prior to or after the sale. If purchased within the 30-day window, denying the chance of claiming a deduction for the loss, you can infuse the loss to the cost basis of the repurchased security, resulting in lower taxes on any tax gains of the new stock.

The purpose of this regulation is to avoid "artificial" losses and to manipulate tax rules by harvesting capital losses to balance income or capital gains through stock trading. The wash sale rule, however, only applies to assets that are technically classed as securities, investments, or other financial instruments traded on established markets.

For now, the cryptocurrencies do not satisfy this requirement, as a result, the investors take due advantage of the heightened volatility of these virtual currencies by selling or immediately repurchasing, without losing any kind of exposure. 

What is Tax-Loss Harvesting?

This is the selling of investments at a loss that is used to offset the capital gains. This means, even with the rule of a wash sale, an investor can utilize the harvesting tax-loss strategy with securities in order to lower the taxable gains of capital. This method usually works by selling an investment at loss with a predetermined intention of repurchasing the same at a later date, outside IRS’ 30-day wash sale rule window.

Having said that, it is a little different from cryptocurrency. There is more than one option when it comes to applying a tax-loss harvesting strategy as the wash sale rule does not apply here.

Let’s understand this with an example

If Sia purchased an Ethereum position for around $10,000 and held it for 18 months, then the value decreases by half in its holding period. Now, at present, she would have a position worth $5,000 with an unrealized capital loss of $5,000.

Next, Sia chooses to sell the stake and recognize a long-term capital loss worth $5,000. In an otherwise stock or security position, she would have expected to wait for 30 days before she could repurchase to avoid the wash sale rule.

Nevertheless, since cryptocurrency isn’t classified as security for the wash sale rule, Sia immediately repurchases $5,000 worth of Ethereum, reestablishing her position. During this process, she locks her long-term capital loss in order to offset the long and short-term capital gains while managing to continue and maintain the position in the cryptocurrency.

Here, the unused balance of capital loss could be used to lower the taxable income by up to $3,000!

What if she acquired $5,000 in Bitcoin on the same day that she bought the $10,000 Ethereum position? Sia would realize a $2,500 long-term capital gain if she sold the Bitcoin on the same day but 18 months later for $7,500, at the same time that she would recognize a $5,000 long-term capital loss from selling Ethereum.

This financial loss may be sufficient to balance the $2,500 investment return, allowing her to reinvest in Ethereum without violating the wash sell rule. The remaining amount might be utilized to reduce ordinary taxable income by $2,500.

Conclude: Closing the Crypto Tax Loophole Window!

Closing of the tax loophole would surely change an attractive element of this burgeoning asset class by generating significant tax revenue for the IRS. After which, the invested investors should be capable of locking the capital losses, as well as, repurchasing their holdings before the end of the year with no risk of encountering the wash sale rule.

This might be subject to change in 2022!

FAQs: Crypto Tax Loophole - What Is it?

1) What is the crypto tax loophole?

The crypto tax loophole is the escape rule that solely applies to financial securities - the “wash sale” rule. This loophole could soon be closed by pending legislation, saving crypto investors a lot of money at tax time.

2) What is the wash sale rule?

The wash sale rule prevents tax deductions of losses from the sale or any other disposition of securities or stock if you purchase the same asset within 30 days, prior to or after the sale. If purchased within the 30-day window, denying the chance of claiming a deduction for the loss, you can infuse the loss to the cost basis of the repurchased security, resulting in lower taxes on any tax gains of the new stock.

3) What is the reason behind the wash sale rule?

This is the selling of investments at a loss that is used to offset the capital gains. This means, even with the rule of a wash sale, an investor can utilize the harvesting tax-loss strategy with securities in order to lower the taxable gains of capital.

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TechGlobeX: Cryptocurrency Taxation: Crypto Tax Loophole Explained
Cryptocurrency Taxation: Crypto Tax Loophole Explained
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