Taxes in the crypto sector can be optimized via crypto tax planning. It helps in the identification of opportunities for the minimization of taxes imposed on crypto transactions. Suppose the crypto assets are donated to any charitable organizations. In that case, it may provide a tax deduction and eliminate the imposition of capital gain taxes on the assets contributed to charity.
Investors use the crypto tax-loss harvesting strategy to decrease the probability of capital gains in their crypto investments. For this purpose, they sell their losing positions at comparatively lower rates. In addition, the crypto tax-loss harvesting strategy also helps reduce their tax liabilities in the market.
This guide article will elaborate on crypto tax-loss harvesting and how this strategy facilitates traders in the crypto market. Moreover, readers will also learn about the risks and challenges of the crypto tax-loss harvesting strategy and the methods to cope with them.
What is Crypto Tax-Loss Harvesting?
Traders in the financial market use the crypto tax-loss harvesting strategy, where a cryptocurrency is sold at a comparatively lower rate than the purchase price.
It facilitates offsetting the capital gains that the trader may earn by selling any other crypto asset at a profit. This reduces the overall tax liability for the investor by balancing any capital gain in the market with the capital losses earned on purpose.
A trader can claim a loss in the trade by selling the asset in the market. He can then proceed further to buy the same asset within a month before or after selling one.
This phenomenon is known as the “wash sale” rule. Individuals and businesses that have invested in several crypto assets in the market can use the crypto tax-loss harvesting strategy. It might help them reduce the massive tax burdens imposed by the higher authorities.
On the other hand, a few countries have a policy where they only offset the losses against all kinds of income rather only against capital gains. Moreover, they also impose restrictions and limits on the amount of loss claimed by the traders. In addition, the year the traders can offset the taxes is also fixed.
The Internal Revenue Service (IRS) operating in the United States has created strict guidelines regarding crypto tax-loss harvesting strategies. These regulations are also imposed on the wash sale rule that does not allow the traders to claim any loss for selling any asset if they purchase the same asset within a month.
Moreover, the amount of capital losses that can be offset is also limited by the IRS. It is set to three thousand dollars annually against an ordinary income.
However, there is no specific wash rule ascribed by the regulatory authorities of the United Kingdom for making crypto investments. However, they do impose some tax principles on the traders. The profit earned through selling assets in the market, including cryptocurrencies, is only prone to applying capital gain tax.
A trader can offset any loss against a capital gain if he sells any asset at a loss in the market. However, he claims the failure in the same tax year or keeps it safe to offset against gains in future tax years.
On the other hand, if the trader purchases the same asset within a short period after selling it at a lower price, the rule of “bed and breakfasting” may be applied to it. The authorities may not accept the loss for deduction purposes.
What is Crypto Capital Gain?
The money earned through trading is known as a capital gain. In the crypto market, income is made through various crypto activities such as royalties, airdrops, liquidity pools, staking, lending, etc. Any income earned through holding a crypto asset for a specific time is known as a capital gain.
When a trader makes money, he is subjected to certain income taxes. In the same way, when money is earned through an asset, it is subjected to capital gain taxes. Capital gain is usually calculated when an investment’s value increases or decreases.
The capital gain tax is not only calculated by looking at the amount one has earned but rather for how long he has held the asset. This period is known as the holding period of an asset. The holding period determines the rate of the tax that will be applied. It will be a short-term gain if the trader has held an asset for less than a year; otherwise, it will be known as a long-term gain.
Working of Crypto Tax-Loss Harvesting
The basic principle behind operating the crypto tax-loss harvesting strategy is the reduction of tax liability. For this purpose, a cryptocurrency is identified in the market that has decreased in price.
It is then sold at a relatively lower price, resulting in a loss for the trader that can be offset against a capital gain in the future. The following steps can help understand the usability of the crypto tax-loss harvesting strategy.
- Identification of Cryptocurrencies Whose Prices Have Decreased
Traders should look out for their trading profiles and examine all the cryptocurrencies they hold. The next step is to look for the ones that have decreased in value with time. This currency will be sold in the market to offset a capital loss.
- Determining the Capital Loss
Capital loss for any cryptocurrency is determined by finding the difference between the purchase price and the sale price of the cryptocurrency identified during the examination of the trading portfolio.
- Offsetting Capital Gains
The capital loss calculated above by selling the cryptocurrency at a lower price can then be used to offset the capital gains. This facilitates the reduction of tax liability.
- Offset Timing
Timing is an important factor in the crypto tax-loss harvesting strategy. It is up to the trader if he offsets his capital gains in the same tax year or carries it forward for future tax years.
- Keeping a Record
As one needs to show the record to the tax authorities, therefore, after carrying out any transaction, the trader should keep track of all the payments made in the crypto tax-loss harvesting strategy.
Risks Involved in Crypto Tax-Loss Harvesting Strategy
Traders can reduce their tax liability to a greater extent by using a crypto tax-loss harvesting strategy. However, several risks are integrated with this strategy, which are discussed below.
- Wash-Sale Rule
The tax code in some countries is composed of the wash sale rule. This rule inhibits the traders from claiming any loss when they sell a currency at a lower price. It is because the trader purchases the same asset within a month before or after the sale. This imposes a major limitation on the utility of the crypto tax-loss harvesting strategy in the market.
- Short-Term vs. Long-Term Gains
Some countries impose a higher tax on short-term capital gains than long-term ones. Short-term capital gain is the profit earned from an asset within less than one year. If one applies the crypto tax-loss harvesting strategy and then buys the same commodity within a few days, it will fall in the short-term gain category even though you have held the asset for a longer period.
- Price Fluctuations in Market
Everyone is aware of the highly volatile nature of the crypto market. Several events and regulations can have an enormous impact on market conditions. Consider a case where an individual sells an asset at a loss, and its price increases in the market after the sale. It is considered a missed opportunity for the trader to earn profit.
As the crypto ecosystem is still evolving, its regulations are also developing with time. Similarly, the rules and regulations regarding crypto tax-loss harvesting can also be complicated to understand.
The Securities and Exchange Commission in the US has issued guidelines that any initial coin offerings can also be considered securities, thus making them prone to federal securities law.
- Lack of Knowledge
One of the major reasons for facing a loss while applying the crypto tax-loss harvesting strategy is not having adequate knowledge about the crypto market. The imposition of certain laws and regulations in the country may cause the traders to miss certain opportunities and lose the trade.
- Lowering the Cost Basis
Applying a crypto tax-loss harvesting strategy lowers the cost basis of an asset. When the price of an asset is higher than the cost basis of that asset, it generates a capital gain for the trader. The more the cost basis of an asset is lowered, the higher will be the capital gain. A higher capital gain leads to a higher tax bill for the trader.
When a crypto tax-loss harvesting strategy benefits a trader in the current year, at the same time, it decreases the utility of his savings for future years due to earning high capital gains on that asset. Moreover, fluctuations in price and income changes may also impact the value of taxes one owes concerning an investment.
The capital gain is calculated using an asset’s cost basis to know the exact taxable amount. This is a downside of the crypto tax-loss harvesting strategy as it may create a loss for the trader even though he may successfully save money from tax bills.
Therefore, before applying the crypto tax-loss harvesting strategy in trade, it is mandatory to consult with the experts and find out the potential benefits of the strategy to earn profit.
Is Crypto Tax-Loss Harvesting Worth It?
Some traders greatly appreciate the utility of crypto tax-loss harvesting strategy in the crypto market as it significantly impacts their earnings in two ways discussed below.
- Decreases the Tax Liability
The implication of the crypto tax-loss harvesting strategy significantly decreases the tax liability for the traders in the year when they harvest the loss. One may be imposed capital gain taxes as high as 20% of the total earning. Although it is not more than the minimum income rate earned by the traders, it is still the fifth part of their total income.
- Saves Money for Future Investments
Secondly, the crypto tax-loss harvesting strategy allows traders to save money to invest in the future. One can offset the probability of paying any taxes on the profit earned through crypto trading and free up that money to invest in better plans.
Is There Any Limit to Crypto Tax-Loss Harvesting Strategy?
There is no limit on the number of times one can harvest losses. However, if the trader faces an overall loss, certain limitations are set by the higher authorities to offset a specific percentage of that loss in federal taxes.
In addition, if the capital loss in a trade move past the capital gains made in a year, one can deduct about three thousand dollars from the loss to offset it against the gain.
However, an amount higher than the capital loss cannot be deducted in a year. For this purpose, the trader can take the capital loss in the future tax years, where he can harvest it against the capital gains in that year.
Methods to Reduce the Crypto Tax Bill
Traders can apply several methods during the trade procedure to reduce their crypto tax bills. A few of them are discussed below.
- Crypto Tax-Loss Harvesting Strategy
Any capital gains earned through selling an asset at a profit in the crypto market can be offset by using a crypto tax-loss harvesting strategy. This is done by selling any cryptocurrency at a loss in the market. This reduces the overall tax liability in the market.
- Holding Period
In some countries around the world, the tax imposed on short-term capital gains is more than the long-term capital gains. Therefore, traders can reduce their tax liabilities by holding their assets for longer than a year.
- Using Tax-Advantaged Accounts
Certain account types may provide significant benefits regarding tax impositions. In some countries, traders can keep their holdings in these tax-advantaged accounts. 401(k) and self-directed IRA are some examples of such accounts.
- Donating in Charities
Traders can also reduce the imposition of taxes on their assets by donating them to a charity. This way, they can dispose of their expensive assets without subjecting them to capital gain taxes.
- Tax Deferral
Individuals in some countries are rolled over into a qualified opportunity fund (QOF) or in a similar kind of exchange. It enables them to offset the probability of paying taxes on capital gains in the crypto market.
A qualified opportunity fund is a type of investment vehicle created as a corporation or partnership for investing in such property. It retains about 90% of the qualified opportunity zone property assets.
Although it is important to look forward to ways of reducing the tax bills in the crypto market, however, they should not be the only goal while trading crypto. The tax regulations related to the crypto market are still developing and can sometimes perplex traders.
In addition, if someone engages in illicit pursuits such as money laundering or tax evasion to reduce his tax bills, it may lead to serious legal situations imposing severe penalties on him.
Methods to Report Crypto Losses on the Taxes
The procedure to report crypto losses on the taxes imposed on trading may vary with the country in which one resides. However, some general methods to report them are discussed below.
- Keep Detailed Records
While making any trade and carrying out any transaction, it is mandatory to keep a complete record of all the related details, including the sale and purchase prices, amount, dates, etc. It proves a lot helpful while the calculation of capital gains and losses.
- Calculate Capital Loss
The next move is calculating the difference between the sale and purchase prices during the transaction. If the purchase price comes out to be more than the sale price, it is considered a loss.
- Follow the Required Steps to Report Losses
There are different approaches followed in other countries to report crypto losses. In some countries, users have to report the loss on the income tax return, while in some places, they will have to submit additional schedules or forms to report any loss.
- Claim the Loss
If the loss the trader faces is greater than any gains earned through crypto trading, he can claim the loss to offset his capital gains.
- Keep the Record Safe
All the documents and details should be kept securely in a safe place for future purposes if asked by any tax authority.
The experts and professionals dealing with crypto taxes can better understand its complexities. Moreover, the requirements and regulations related to crypto tax-loss harvesting vary in every country.
Although earning profit in the crypto market is the major goal most traders set, traders can use the bear markets to lower their tax liabilities. Crypto tax-loss harvesting strategy has greatly compensated for unrealized losses in crypto trading. It can offset any capital gain earned in the crypto market by selling an asset at a loss.
Traders can greatly improve their long-term profit and add diversity to their trade portfolios by understanding the difference between the application of tax-loss harvesting strategy in traditional currencies and cryptocurrencies.