Because crypto can be volatile, using tax-loss harvesting to offset capital gains has been relatively easy for crypto traders to execute — mainly because these investors haven’t had to worry about the wash sale rule.
Under the current wash sale rule, investors cannot sell ordinary securities at a loss (such as stocks, bonds, exchange-traded funds), and then buy back the same or similar securities and still claim the loss to offset other capital gains. But crypto investors can.
That’s because, for now, the IRS does not classify cryptocurrency as a security; it is considered property. So crypto investors may therefore sell crypto that has fallen in value, lock in the loss, and then buy it back again immediately — a wash sale — while still being able to offset investment gains for a tax benefit.
This may change if legislation that’s pending ultimately passes Congress, so it’s wise to be informed about the wash sale rule and how it could affect cryptocurrency trading.
What Is the Wash Sale Rule?
The wash sale rule prevents investors from selling an investment loss just for the tax-loss harvesting benefits while essentially maintaining their position in the security. For instance, if an investor sells 100 shares of stock ABC at a loss on October 1 and then repurchases 100 shares of ABC on October 15, they would not be able to use the tax advantages from the losses from the sale on October 1.
A wash sale occurs when an investor sells a security at a capital loss, and then buys the same or “substantially identical” security within a 61-day window, either 30 days before or after the sale.
Investors often take advantage of investments that have declined in value, selling the securities at a capital loss to offset the capital gains tax they may owe on the profits of other investments they’ve sold.
Known as tax-loss harvesting, investors commonly use this strategy to minimize investment tax liability. And for years, crypto investors have been able to claim multiple losses — some of which can also offset up to $3,000 in personal income — to offset gains, without having to worry about the wash sale rule.
💡 Recommended: Crypto Tax Loss Harvesting Guide for 2022
Does the Wash Sale Rule Apply to Cryptocurrency?
While crypto transactions aren’t subject to the wash sale rule at the moment, excessive crypto wash sales could still cause investors issues with the IRS. This is because crypto wash sales may fall under the IRS’ Economic Substance Doctrine, which states that crypto wash sales must have economic substance — like altering your exposure to market risk — to be eligible for tax benefits.
Because the crypto market can be highly volatile, crypto transactions often have economic substance, so its likely investors could still claim the tax loss benefits even if they repurchased the same crypto shorting after selling.
Nonetheless, the wash sale rule is something that all investors need to be aware of when trading different types of cryptocurrency. By understanding the rule and how it applies to cryptocurrency, investors can ensure they are taking advantage of all the tax benefits available to them.
💡 Recommended: Crypto Tax Guide 2022: How to Report Crypto on Your Taxes
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Example of Crypto Wash Sale
A crypto wash sale occurs when an investor sells a specific cryptocurrency at a loss but buys the same cryptocurrency 30 days before or after the sale date.
For example, suppose an investor buys $5,000 worth of a specific cryptocurrency. This crypto then falls in value by half, trading at $2,500. The investor can sell their position, incurring a $2,500 loss, but immediately buy back $2,500 worth of the crypto to maintain their position. The investor could claim $2,500 of capital losses on their taxes but still have a position in the crypto.
Crypto investors often use a wash sale to lock in a capital loss for tax benefits but still maintain a position in a specific crypto.
However, the IRS could still flag this strategy for tax loss harvesting. The IRS may disallow a wash sale if a taxpayer is in the same economic position after the transaction, as in the example above.
The best way to avoid issues with crypto wash sales is to wait to repurchase the specific crypto asset after the 30 days period; this way, the transaction no longer classifies as a wash sale.
Will the Wash Sale Rule for Crypto Change in the Future?
As noted above, the wash sale rule doesn’t currently apply to crypto, but that could change in the future.
The Biden administration tried to change how the wash sale rule applied to crypto as part of the Build Back Better legislation. If it had passed, this bill would have made crypto subject to the wash sale rule like stocks and other securities. However, this bill stalled in Congress.
Investors should be aware of the evolving nature of how tax rules apply to cryptocurrency since it is still a nascent asset class. There will likely be further regulation of cryptocurrency in the future, which could affect how the wash sale rule applies to crypto.
The Takeaway
The wash sale rule is a tax rule that says you can’t deduct a loss on the sale of an asset if you buy the same or similar asset within 30 days before or after the sale. The wash sale rule applies to stocks, bonds, and other securities, but does not usually apply to cryptocurrency.
Many crypto traders use wash sales as part of a tax-loss harvesting strategy to minimize tax burden while maintaining a position in their crypto holdings. However, the evolving tax rules surrounding crypto may limit this benefit in the future. Crypto traders need to stay up to these changes when it comes to managing a crypto portfolio and tax liability.
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