Cryptocurrency and the Wash Sale Rule: A Tax Loophole That May Soon Go Away

You might not realize it by looking at today’s booming crypto market performance, but in the not-too-distant past, cryptocurrencies fell to some of their lowest prices of the year. Bitcoin hit an all-time high in May but then quickly pulled back to lower levels. Nearly every cryptocurrency followed suit. This wasn’t the first time it happened, and it’s almost surely not the last.

While this might seem like a distressing situation for investors speculating on these coins’ long-term appreciation potential, some alert investors welcome opportunities like these with open arms. Why?

The IRS classifies virtual currencies like Bitcoin, Ethereum, Dogecoin or even Shiba Inu as property. This means crypto investors are subject to the same taxes on capital gains and losses that apply to other investors, but with one important difference. They escape one rule that applies solely to financial securities: the “wash sale” rule.

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This tax loophole, which might soon get closed by pending legislation, can save cryptocurrency investors a lot of money come tax time. Unlike people investing in securities, crypto investors can take full advantage of the tax-loss harvesting rules without having to time out virtual currency purchases to comply with the wash sale rule. So, if you own crypto and plan to implement a tax-loss harvesting strategy, it’s important to know what is and isn’t allowed. To get you up to speed, let’s delve deeper into tax-loss harvesting, wash sales, the wash sale rule, and how the current landscape might change for cryptocurrency investors.

What is a Wash Sale?

You experience a wash sale when you sell or trade a security at a loss and then buy it or a substantially similar security back after a short period of time. (Selling at a loss entails disposing of the asset at a fair market value below that of your original cost basis.)

Investors use wash sales to maximize the tax deductions allowed after selling a position in a loss-making security. For example, if an investor sells a security at the end of the calendar year and then repurchases it at the start of the new year, he or she could lock in a loss for tax purposes but remain invested in the security going forward.

Seeing this method of “gaming” the tax system, the IRS limited the practice by establishing the wash sale rule.

What is the Wash Sale Rule?

The wash sale rule generally disallows tax deductions for losses from the sale or other disposition of stock or securities if you buy the same asset (or substantially similar one) within 30 days before or after the sale. If you choose to repurchase the same or similar security within the 30 day window, denying you the chance to claim a deduction for your loss, you can add the loss to the cost basis of the newly repurchased security. As a result, when you choose to sell the new stock later, any capital gains taxes you’d pay will still be lower.

The intent behind the wash sale rule is to prevent the creation of “artificial” losses and the manipulation of tax laws by trading in and out of a stock for the purposes of harvesting capital losses to offset capital gains or income.

However, the wash sale rule only applies to assets formally classified as securities, investments like stocks, bonds, ETFs and other financial instruments that are traded on organized exchanges. Cryptocurrencies, at least for now, don’t satisfy this requirement. As a result, some investors take advantage of the heightened volatility of many virtual currencies by selling a position to lock in a capital loss and immediately repurchase it without losing exposure to the cryptocurrency.

As an example, imagine you purchased Ethereum, one of the best investments of 2021, and established a $10,000 cost basis. If the cryptocurrency declined by 50% in value and you chose to sell your entire position, you’d have a $5,000 capital loss.

This capital loss would first go toward offsetting any capital gains recognized during the year with any unused balance lowering your ordinary taxable income by up to $3,000 for the calendar year. Any remaining balance rolls forward indefinitely to future years to offset future capital gains or taxable income until fully exhausted.

If you wanted to remain invested in Ethereum, you could repurchase those same coins immediately after selling them, locking in a loss but keeping the crypto in your portfolio. If you attempted to do the same with a stock position you held, this loss would be disallowed under the wash sale rule, preventing you from offsetting any capital gains or taxable income.

What is Tax-Loss Harvesting?

Generally, tax-loss harvesting is the selling of investments at a loss and using the loss to offset capital gains. Even with the wash sale rule, you can still utilize a tax-loss harvesting strategy with securities to lower your taxable capital gains. This works by selling an investment at a loss with the intention to repurchase it at a later date, outside of the IRS’ 30-day wash sale rule window.

It’s different with cryptocurrency, though. There are more options when applying a tax-loss harvesting strategy, since the wash sale rule doesn’t apply. For example, imagine you purchased an Ethereum position for $10,000 and you held the asset for 18 months. The value decreased by half during this holding period. You now have a position worth $5,000 and an unrealized capital loss of $5,000.

You could sell your stake and recognize a long-term capital loss of $5,000. If this was a stock or other security, you’d have to wait 30 days before repurchasing to avoid the wash sale rule. However, because cryptocurrency isn’t classified as a security for wash sale rule purposes, you can have your cake and eat it too by immediately repurchasing that same $5,000 worth of Ethereum and reestablishing the position. In the process, you lock in your long-term capital loss to offset long-term and short-term capital gains while continuing to maintain a position in the cryptocurrency. The unused capital loss balance can then be used to lower your taxable income by up to $3,000.

Now, imagine you also bought $5,000 worth of Bitcoin the same day you initially purchased your $10,000 Ethereum position. If you sold your Bitcoin on the same day 18 months later for $7,500, you would recognize a $2,500 long-term capital gain at the same time you recognized a $5,000 long-term capital loss from selling your Ethereum. This long-term capital loss could offset this $2,500 investment return while also allowing you to reinvest in Ethereum without worrying about the wash sale rule. The balance of this long-term capital loss could be used to lower your ordinary taxable income by an additional $2,500.

Closing Window for the Crypto Tax Loophole

Given the growing popularity of cryptocurrencies, Congress is considering a tax law change that would make the wash sale rule applicable to cryptocurrencies. Closing this tax loophole would change one attractive element of this burgeoning asset class and generate significant tax revenue for the IRS.

Interested investors should be able to lock in capital losses and repurchase their holdings before year’s end without risk of encountering the wash sale rule. Starting in 2022, though, that might be subject to change.