The Crypto Loophole That Saves You a Lot of Money: Crypto Wash Sale Rule

The Crypto Loophole That Saves You a Lot of Money: Crypto Wash Sale Rule
pic credit: CNBC

This article will literally save you thousands of dollars if you're in the crypto field. Today, we're going to discuss a specific crypto loophole called the Wash Sale, which may be changed in the coming months. This is still applicable today. 

To begin, consider this post to be a complement to my guide on crypto taxation. I mentioned in that article that you should account for both your losses and your gains because you can save money by doing so. This is because you can claim a tax deduction when you sell an investment for a loss. 

Let's imagine you made $5,000 this year by buying Bitcoin, but you also lost $300 by selling Ethereum. You can lawfully deduct the $300 loss from the taxes you owe on your $5,000 gain, but there are usually restrictions in most situations. 

Because losses can now be written off, many investors engage in a practice known as Tax-Loss Harvesting. You're essentially selling your assets at a loss in order to deduct those losses from subsequent gains. This may be sufficient to offset some of the taxes due on regular income or capital gains for the year. It's a lot of fun.  

This is where the trick comes in

You might receive a good idea after selling at a loss. What if you sell at a loss and immediately purchase back in? In this manner, I may deduct the loss from my taxes while still having exposure to the asset in case the price rises in the future. 

And to this, I would advise you to take it a little easier on yourself. You're in the correct frame of mind, but it's not that straightforward. The IRS has restrictions in place to prevent you from creating false losses in financial securities, which is the first major stumbling block. 

This is where the Wash-Sale regulation comes into play. However, there is an exception for us. You can't purchase back the assets you've sold if you sell financial securities like stocks and bonds after a certain amount of time has passed. 

Simply said, the IRS noticed people doing this in the past and enacted a law stating that if you sell an asset, such as a stock, you cannot buy the same security or a "Substantially Identical Security" 30 days before or after the sale and claim the loss as a tax deduction. As a result, there will be no artificial losses in financial securities. 

Also, take note of how I said Before or After. Unfortunately, there's a 61-day gap where you can't acquire the identical stock to effectively rig the tax system to your benefit. You're probably turning white right now, staring over your crypto rap sheet, thinking to yourself, "Well, this isn't going to help me, but I have some exciting news." This restriction does not apply to crypto holdings for at least the rest of this year 2021. 

Why is that, you might wonder? 

Because the SEC does not consider cryptocurrency to be a form of financial security At least not yet. That means you can buy and sell as much cryptocurrency as you like, and your crypto losses can be deducted from your taxes. 

You can even deduct up to $3000 each year from your ordinary income. And I understand this sounds too good to be true. Before I show you how to do it, I'd like to remind you that this is only for fun purposes. I'm not your financial advisor, after all. 

Let's look at an example. Assume an investor purchased the Squid game token, which eventually depreciated to $0, which he then sold. We'll refer to him as Jimothy. He lost $20,000 and has never purchased cryptocurrency again. 

He can deduct the $20,000 loss from his regular income, such as wages, salary, tips, bonuses, and interest. Make a case for it. There is, however, a limit. Until all of his losses are covered, he can only claim $3,000 per year against regular income. 

So Jimothy will get a $3,000 deduction for the next six years, a partial $2,000 deduction for the seventh year, and his entire $20,000 will be accounted for at this time. This is fantastic since it can save you a lot of money. 

But let's take it a step further and use the lack of wash sale laws in bitcoin to our advantage. And this is where you can save tens of thousands of dollars more. Jimothy invests $40,000 in Jim coin, a cryptocurrency created particularly for people with the name "Jim." No one expected it, but Jim's coin tanked. Jimothy's stack is now valued at $20,000! 

He wants to profit from his loss, but he also wants to be in Jim coin since there are reports that Jim Crammer would discuss it, and he wants Jim coin publicity. So Jimothy sells his position at $20,000 and immediately buys it back. 

His position is still worth $20,000, and he now has a $20,000 capital loss to deduct from his taxes. Jimothy, on the other hand, has some capital gains. He's been purchasing and selling other projects and has a total profit of $10,000. At the end of the year, he has $20,000 in short-term losses and $10,000 in short-term gains. 

First, Jimothy can combine the $10,000 in gains with the $20,000 in losses, resulting in a capital gain of $0 on the $10,000 in gains. He now has $10,000 leftover, which he can utilize to deduct either future capital gains or $3,000 each year from ordinary income. And this is when it gets interesting. 

Let's pretend Jimothy's short-term capital gains and ordinary income tax rates are both 22% for the sake of simplicity. Instead of simply holding Jim's currency, he sold and rebought it. 

He saved $2,200 in taxes the first year by being able to deduct the $10,000 gain, and he saves another $2,200 over the next four years by deducting up to $3,000 in ordinary income each year. By simply clicking the Sell and Buy buttons, you can save $4,400. That's it. 

Additional Things You Should consider

Now there are a few more things to think about. You're probably already familiar with what I've said so far if you've been using tax-loss harvesting as a strategy. Because cryptocurrency assets aren't yet deemed financial securities, they're a great opportunity to rack up capital losses before the end of the year. 

This is true in many countries other than the United States. If you don't live in the United States, double-check. Because cryptocurrency is such a wild beast, it's simpler to see opportunities to sell at a loss and then reopen the position to save money on taxes. 

When compared to equities or exchange-traded funds (ETFs), the price changes in considerably smaller amounts. However, the government's attitude toward cryptocurrency holdings is likely to shift in the near future. 

New rules are already being implemented, such as the $1.2 trillion infrastructure plan. In case you missed it in my previous analysis, the government expects to generate $28 billion in tax income from crypto alone, thanks to new reporting rules imposed on crypto "brokers" - a term that needs some clarification.

 Don't expect the wash sale loophole to last indefinitely until we learn more. And, if crypto becomes financial security in the eyes of the SEC, the increased volatility in crypto might potentially do more harm than good to your wash sale approach. 

For example, if you decide to close your position to take advantage of a tax loss while Bitcoin is at a lower price, having to wait 31 days before re-entering the market could result in you paying a higher price for those coins. 

However, I discovered an unusual workaround: ETFs aren't regarded identical or significantly comparable to stocks. If you wanted to lock in tax losses, you might terminate a stock position and reinvest the proceeds in an ETF that holds the same stock. Of course, your exposure will be different, but that's kind of the point. Because the ETF is unique, the IRS will not consider your losses to be artificial. 

After your 31-day lockout period expires, you can keep the ETF or close it to reopen a stake in the stock you previously held. Because of the recently approved futures ETFs for Bitcoin and other cryptocurrencies, this is now applicable. If the wash sale regulation is changed, this could become a popular approach for crypto tax-loss harvesting very soon. 

If you've never employed a tax-loss harvesting approach before, keep in mind that the Wash-Sale rule prevents your spouse or a corporation you control from purchasing the asset for you, and you definitely shouldn't have your wife's boyfriend purchase a stock for you either. 

Some other flaws in financial securities

If you haven't noticed, I've already cited the IRS as stating that the Wash-Sale rule applies to the same or substantially comparable assets. We don't yet know how these laws will apply to cryptocurrency because it hasn't been legally recognized as a financial asset. But first, let's look at some other flaws in financial securities to gain a better understanding. 

So, if this change occurs in the future, we can plan ahead with crypto. So far, we've established that stock and an ETF that holds a stock are not deemed to be essentially equivalent assets. But what about stocks from similar companies? 

The good news is that, even if they move in the same direction, equities from various firms in the same industry are not considered identical. So, instead of waiting for the Wash-Sale lockout period to end, you can take a capital loss on the sale of some stock in Company A and reinvest the funds in Company B. 

Taking things a step further, selling preferred stock in a firm and buying common stock in the same company isn't always regarded as substantially similar, though there are exceptions. When you can trade between the two without restrictions, some businesses' preferred stock is labeled as identical. 

If this is part of your tax-loss harvesting strategy, or really any of these circumstances, it's always preferable to have someone look at the numbers for you because no two instances are the same.

Bottom Line

So, if the Wash-Sale rule is implemented for cryptocurrency, we can expect that selling one coin or token to buy another will not be considered substantially equivalent. 

In any case, until the rules change, we can take advantage of the loose laws by selling and rebuying any crypto when prices fall below our cost basis, allowing us to save thousands of dollars in the future.

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