Crypto Tax-Loss Harvesting Guide: Turn Losses Into a Tax Benefit

Tax-loss harvesting is a popular tactic used by many investors who hold traditional assets such as stocks or bonds, and it can also be applied to cryptocurrency investments. Crypto tax-loss harvesting follows the same principles as ordinary tax-loss harvesting, except it can be used by crypto investors to reduce their tax liabilities.

Crypto tax-loss harvesting is particularly relevant for 2022, when many investors have seen steep crypto losses. The upside is that tax-loss harvesting allows crypto investors to offset their losses against other capital gains in their portfolio.

Ultimately, tax-loss harvesting may help crypto investors lower the amount they owe in taxes — an important benefit, given how volatile crypto can be. And for various reasons, the current rules have been more favorable for crypto traders, although that could change.

What Is Crypto Tax-Loss Harvesting?

Tax-loss harvesting, and by extension, crypto tax-loss harvesting, is primarily a way to lower or even eliminate capital gains taxes on your investment gains for a given tax year. Although tax-loss harvesting has traditionally been a tactic used with traditional assets, like stocks, bonds, or ETFs, tax-loss harvesting crypto investments is simply using crypto investments to harvest tax losses.

With tax-loss harvesting, an ordinary investor can sell assets that have dropped in value and use the losses to mitigate the capital gains tax they may owe on the profits of other investments they’ve sold.

For example, if an investor sells a security for a $25,000 gain, and sells another security at a $10,000 loss, the loss could be applied so that the investor would only see a capital gain of $15,000 ($25,000 – $10,000). That’s the main benefit of tax-loss harvesting.

The same basic rules apply to crypto investors, with the exception of the wash sale rule. This is covered in more detail below, but essentially the wash sale rule prohibits securities investors from selling investments to lock in a loss — and then repurchasing the same investments within 30 days. If an investor violates the wash sale rule, they can’t use their losses to offset taxable gains.

This isn’t true for crypto investors at the moment. Currently, crypto investors aren’t covered by the wash sale rule, so they can sell crypto holdings at a loss, use the realized loss to offset capital gains, and then repurchase the same crypto they just sold.

While there’s more to the strategy than just a 1:1 application of losses to gains, as you’ll see in the sections below, a tax-loss harvesting strategy can be an important part of a tax-efficient investment strategy.

Note that an investor has to actually sell the asset to create a taxable event, otherwise, it’s still an “unrealized” loss. Tax loss harvesting only comes into play when you sell your holdings at a loss.

How Crypto Tax-Loss Harvesting Works

When engaging in tax-loss harvesting to try and lower your tax liability, remember that there are a lot of variables at play. Those can include the specific asset being sold, how long the asset was held, and even your household income and tax filing status.

Example of Crypto Tax-Loss Harvesting

But to keep things simple, here’s an example of crypto tax-loss harvesting:

Let’s say the value of your Bitcoin holdings is down by $5,000. If you sell your Bitcoin and take the loss, you can then apply that $5,000 to offset other investment gains realized in the same calendar year. You’re not limited to applying crypto losses to crypto gains. So if you have investment gains of $10,000 in total in a given year, the $5,000 loss would reduce your taxable gain amount to $5,000 for that year.

That said, there are two types of capital gains: Short-term (less than one year) gains, and long-term gains (for assets you’ve held for a year or more). Depending on how long you’ve held different investments, you could owe more or less when it comes to capital gains . That’s because long-term gains are taxed at a more favorable rate; short-term gains are taxed at the higher capital gains rate.

Be sure to consider which assets you’re selling and when, because the IRS applies like to like: short-term losses to short-term gains and long-term losses to long-term gains first. After that, your investment losses generally offset any gains, and can be carried forward (see below).

Note, too, that some investors can use automated tax-loss harvesting tools to do the heavy lifting for them when it comes to tax-loss harvesting.

How Much Can You Tax-Loss Harvest?

The limit you can tax-loss harvest is determined by the amount of your losses versus your gains. You can only harvest the investment losses you have for a given calendar year and apply them to the investment gains you realized in the same calendar year.

If capital losses equal your capital gains, they would offset one another on your tax return, so there’d be nothing to carry over. For example, a $10,000 capital loss would cancel out a $10,000 capital gain.

If your losses exceed your gains, there is a remedy.

What If You Have More Losses Than Gains?

In order to allow taxpayers to claim the full capital loss deduction they’re entitled to, the IRS allows investors to carry tax losses forward into future years using a strategy called a tax-loss carryforward.

This means, generally speaking, that you can report losses realized on assets in one tax year on a future year’s tax return. IRS loss carryforward rules apply to both personal and business assets.

Thus, if your capital losses exceed your capital gains, you can claim the lesser of $3,000 ($1,500 if married filing separately) or your total net loss shown on line 21 of Schedule D for Form 1040. Any capital losses in excess of $3,000 could be carried forward to future tax years. The IRS allows you to carry losses forward indefinitely.

When Is Tax-Loss Harvesting Crypto Worth It?

Tax-loss harvesting is somewhat of an advanced investment strategy, so whether or not it’s worth it depends on your specific financial picture. If you only have a handful of crypto investments, for instance, and don’t plan on selling any of them, tax loss-harvesting crypto may not really be necessary.

The strategy itself is most useful when the benefits are greater than the costs to you (crypto tradings costs, fees, etc.). But if you’re a fairly active crypto investor, cryptocurrency tax-loss harvesting may indeed be worth it. The best course of action, however, is probably to consult an accountant or financial professional for guidance.

When Is the Best Time to Tax-Loss Harvest?

Generally, many investors engage in tax-loss harvesting at the end of the year in order to lock in their gains and losses for the tax year. That’s mostly because people are looking for ways to lower their potential tax bills, and some year-end portfolio moves can often help them do it. But it’s a strategy that can be used year-round — not merely to end the year.

Pros and Cons of Tax-Loss Harvesting

Naturally, if you want to tax-loss harvest crypto, there are some pros and cons to be aware of.

Pros	Cons
Can lower or eliminate capital gains, thereby reducing your tax bill	Costs of tax-loss harvesting may outweigh benefits
Excess losses can offset personal income tax, and carried forward to future tax years	May benefit high income investors more
No wash sale rule	Could throw off your asset allocation

Is Tax-Loss Harvesting Crypto Legal?

Yes, crypto tax-loss harvesting is legal for now. Under the Build Back Better Act, some provisions might have changed how crypto investors carried out their tax-loss strategies, but that law has yet to pass Congress.

What About Wash-Sale Rules?

Usually, when discussing tax-loss harvesting, investors need to be aware of wash-sale rules. This IRS rule states that if you sell an investment to claim a loss, and then buy the same asset back within 30 days (pre- or post-sale) — what’s known as a wash sale — you forfeit the ability to claim the capital loss as a tax benefit.

Basically, it’s the IRS’ way of stopping investors from taking advantage of the system. If you could sell Stock X to claim a loss only to turn around and rebuy Stock X 10 minutes later, then you’re not really realizing a loss, per se.

But crypto investors don’t need to worry about wash sale rules, at least for now. In something of a loophole, wash sale rules don’t apply to cryptocurrencies because the IRS taxes crypto as property, rather than as securities.

Until the IRS says otherwise, crypto is unaffected by wash-sale rules. But as noted above, there is legislation currently being considered that could close this loophole for crypto investors by apply wash-sale provisions to crypto trades as well.

The Takeaway

Tax-loss harvesting cryptocurrency can provide crypto investors with a method for reducing their taxable income. Since crypto trading is unaffected by the wash-sale rule, it may be a relatively easy way for sophisticated investors to lower their tax bills. But it’s not foolproof, as the costs of crypto loss-harvesting may outweigh the potential savings.

FAQ

Is there a limit to how much you can tax loss harvest?

Not really. As long as you have investment gains that match your losses, you can use those losses to offset any taxable gains. There is a limit if you want to carry losses forward to future tax years. The limit is $3,000 ($1,500 if you’re married, filing separately).

Can you avoid capital gains tax on crypto?

The easiest and most obvious way to avoid capital gains tax on crypto is to hold it, rather than sell it, which triggers a taxable event. Other than that, you can gift your crypto holdings to avoid taxes on gains.

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Photo credit: iStock/xavierarnau

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