Cryptocurrencies like Bitcoin, Ethereum, and the like have provided investors countless ways to build real wealth. Of course, everyone wants to make a killing, and many people have. Making a tidy profit off crypto feels incredible – until the IRS sends you a capital gains tax bill. If you’re sweating in anticipation of your next crypto gains bill, you might be interested in crypto tax-loss harvesting.
While most new crypto investors may think that losses on your investment are always bad, that’s not necessarily the case. Keep reading to learn more about using crypto tax-loss harvesting to turn your losses into wins.
What Is Crypto Tax-Loss Harvesting?
At its core, tax-loss harvesting is just using part or all of your capital losses to offset your capital gains. Each year, you can use up to $3,000 worth of losses towards offsetting your normal income. The real benefit comes from being able to then carry any additional losses forward into the following year.
So let’s say you’ve had a less-than-stellar 2022 and finished the year with about $10,000 in losses in your crypto portfolio. When it comes time to pay your 2022 taxes, you’ll be able to lower your taxable income by $3,000 and carry forward an additional $7,000 in losses.
Let’s say things turn around for you in 2023, and you finish the year with $50,000 in capital gains. You’ll have a higher tax bill due to your higher earnings. However, you can still reduce your taxable income by $3,000 and carry forward another $4,000 from your 2022 losses.
When Should I Take Advantage Of Tax-Loss Harvesting?
Crypto has a few unique characteristics that make it particularly suitable for tax-loss harvesting. Remember, you can only use the loss-harvesting method when you lose money on your investment. Therefore, you’ll have to sell your crypto for less than you originally paid – assets you are still holding that have lost value do not qualify as losses.
Because some cryptocurrencies can be highly volatile, crypto investors may have multiple times per year that they can take advantage of tax-loss harvesting. Here’s a simple example to help you better understand the strategy.
Let’s say you originally purchased $10,000 worth of Dogecoin at $.13 in March of 2022. In May 2022, it dropped to around $.08, a nearly 40% decrease and a loss of almost $4,000. To take advantage of tax-loss harvesting, you would first:
- Sell your Dogecoin at $.08 for a loss of about $4,000
- Buy back more Dogecoin at the lower price point
You’ve now registered a capital loss that you can use to offset your capital gains, and you’re still invested in the coin at a lower price point. Keep in mind this is a basic example of how this strategy works, but there are a few things to watch out for.
Keep an Eye Out for Crypto Wash Sales
One of the reasons why crypto makes the perfect candidate for tax-loss harvesting is due to the wash sale rule. The term “wash sale” refers to harvesting losses (selling stocks or securities at a loss) and then purchasing the same stocks or securities back within 30 days before or after the sale. The IRS does not allow taxpayers to deduct those losses on normal securities.
However, the wash sale rule doesn’t apply to cryptocurrency or other digital assets because it’s considered “property,” not a “security.” Thus, cryptocurrency tax-loss harvesting is often far more lucrative than traditional harvesting with stocks or securities. You can sell, repurchase, and then sell the same cryptocurrency again without waiting 30 days.
Be aware that Congress is in the process of trying to eliminate loopholes like crypto wash sales, so it’s essential to take advantage of it while you still can.
How to Benefit from Crypto Tax-Loss Harvesting
The primary benefit of cryptocurrency tax-loss harvesting is the savings you’ll gain on your yearly tax return. However, the harvesting method can provide significant benefits and help you grow your investment returns over the long run.
For the tax year that you harvest your crypto losses, you’ll notice a dramatic reduction in your tax liability. With capital gains tax rates as high as 20%, Uncle Sam can take a big bite out of your yearly returns.
Let’s take it a step further and say you end up with capital losses after calculating your gains for the year. If so, you can deduct up to $3,000 of those losses from your regular income. As the standard income tax rates can be as high as 37%, you can see how the savings can add up. Plus, the tax savings you gain from loss harvesting is money you could reinvest, further driving up your overall return and annual profits.
The Risks Involved with Crypto Tax-Loss Harvesting
As with any other investment opportunity, you should know the risks before using this strategy. Here are a few drawbacks to consider:
- You could incur hefty transaction fees depending on the exchange you use to buy and sell. If the fees are high enough, it could cancel out your potential wins.
- Loss harvesting is an excellent way to defer your capital gains and reduce your tax liability, but it doesn’t eliminate them altogether.
People in certain situations may not benefit from this tax reduction method, such as the following examples:
- Your tax savings aren’t high enough to cover the crypto exchange or transaction fees.
- You fall under the income bracket with a capital gains tax rate of 0% (single and making under $40,000 or married couples under $80,000).
- You’ve held your crypto for less than one year, subjecting you to the short-term capital gains tax rate of 10 to 37% instead of the long-term of 0 to 20%.
How Often Should Crypto Losses Be Harvested?
There’s no hard and fast rule as to when you should use tax-loss harvesting. The best strategy is to keep track of your unrealized losses and any potential market drops that could provide you with a lucrative opportunity.
Many people prefer to harvest losses at the end of the financial year. However, if you really want to maximize your benefits using loss harvesting, you should remain vigilant regarding crypto market trends throughout the calendar year. Just be sure to realize your losses before the financial year ends to claim the losses on your upcoming tax return.
Does a Limit Exist to Crypto Tax-Loss Harvesting?
Yes. While there’s no limit to the amount of crypto you can sell or trade, there is a strict limit for a capital loss offset. Simply put, you can’t offset an unlimited amount of losses against your gains every year. The limits vary from country to country:
- United States: $3,000 offset limit against taxable income
- Canada: 50% offset limit of your total losses
- United Kingdom: No limit
- Australia: No limit
While the U.S. has a $3,000 limit for offsetting losses against your capital gains, there’s a silver lining: you can indefinitely carry forward any losses above the $3,000 to the following year.
Cost Basis Methods for Cryptocurrency Tax-Loss Harvesting
Cost basis methods for crypto tax-loss harvesting are essential for investors who want to offset their capital gains tax bill. While the United Kingdom and Canada have strict regulations regarding cost basis for capital assets such as crypto, the United States offers investors much more flexibility.
Investors use a cost basis system to calculate the value of assets they hold in a taxable account to discover their profit or loss for tax reporting purposes. Cost basis refers to the original asset value, which investors compare with the sale price, thus determining whether they gained or lost. Most investors use one of four primary methods for calculating cost basis: FIFO, LIFO, HIFO, and Spec ID.
First In, First Out (FIFO)
The FIFO cost basis method is simple. The first assets you acquire are the first ones to go when determining your losses and gains. Remember, the IRS charges short-term investments (those you hold less than a year) at a much higher tax rate. However, that rate drops when you’ve held those assets for over 12 months, which means you get more tax savings. Therefore, selling your oldest assets first is better to avoid paying a higher tax rate.
Last In, First Out (LIFO)
LIFO is the opposite of FIFO: instead of selling your oldest shares first, you sell the newest acquisitions, followed by your other previously purchased shares. LIFO is an excellent choice for investors who want to hold onto their initial shares. Then, you calculate your gains or losses using the difference between the most recent purchase price and the original sale price.
Highest In, First Out (HIFO)
The HIFO cost basis method stands for highest in, first out. So, if you invest in crypto on multiple dates, the purchases you spent the most money on would be the first to go. Therefore, selling shares with the highest price point first allows you to maximize your capital losses and minimize gains—plus, you don’t have to spend time choosing what to sell; you already know you’re liquidating the most expensive.
Specific Identification (Spec ID)
The Spec ID method of cost basis isn’t as popular as FIFO or LIFO despite its excellent flexibility, and it requires you (or your accountant) to maintain scrupulous records. When using the Spec ID cost basis method, you pick precisely which shares you want to sell or trade, usually based on what will be the most advantageous to your current investment strategy.
The Legality of Tax-Loss Harvesting
Many people mistakenly believe that tax-loss harvesting is a form of tax evasion, but it’s not. It’s 100% legal in the U.S. as long as you follow the rules. For conventional securities like stocks and bonds, you may not sell your investments and then repurchase them (or substantially similar ones) before 30 days pass, which is a wash sale.
However, wash sales don’t apply to cryptocurrency sales. Also, you may not offset more than $3,000 of losses against your capital gains in one financial year, but you can roll the excess over to the next. While tax-loss harvesting is legal, many financial experts recommend against using it as a primary investment strategy.
Avoid Capital Gains On Crypto By Investing In A Crypto IRA
While investment strategies like tax-loss harvesting help minimize your yearly tax liability, they usually won’t eliminate your capital gains taxes altogether. If you’re looking for a way to invest in crypto and avoid your capital gains taxes, buying crypto in an IRA is one of the best ways to do that.
My Digital Money is a safe, straightforward, and transparent crypto IRA platform that gives investors of any skill level an easy way to buy and sell cryptocurrency and grow long-term, tax-deferred wealth. If you’d like to learn more about our platform or some help getting started, call us at (833) 636-2008 or reach out to our crypto experts online.