Most traders and investors try to buy low and sell high. But smart traders know that intentionally locking in their losses can significantly impact their success. While it sounds a little crazy to lock in your losses, this “tax loss harvesting” strategy can help you save serious money come tax time and boost your after-tax returns.
In this article, we’ll examine the concept of locking in losses, the rules and mechanics of tax loss harvesting, and tools you can use to automate the process.
Locking in Crypto Losses
Suppose you invested in a token that has been down 40% since the original purchase, but you believe it will eventually come back and rise above the purchase price.
Rather than holding the token until it rises, you might want to “lock in” the loss by selling it for a 40% loss. You can then repurchase the token after 30 days (more on that later) or purchase a similar token to maintain your crypto allocations. In investor circles, this strategy is known as “tax loss harvesting” (TLH).
By selling at a 40% loss, you “realize” the loss, making it eligible for a write-off. In other words, you can use the loss to offset other capital gains in your investment portfolio or up to $3,000 per year in ordinary income. And you can carry forward any realized losses you cannot use during the current tax year to future years!
You’ll calculate these losses on Form 8949, report them on Schedule D, and carry them over to Form 1040 on Line 7 of Schedule 1 (Additional Income and Adjustments to Income), where they factor into your total year-end tax obligation.
The Mechanics of TLH
Tax loss harvesting can help you generate write-offs and reduce your tax liability, but it has specific rules and restrictions. After all, it’s easy to see how someone could continuously lock in “losses” without accruing a “real” loss.
The Wash Sale Rule is the most critical rule preventing investors from selling a security at a loss solely for tax purposes. In particular, the rule states that you cannot sell a security at a loss and buy the same or a “substantially identical” security within 30 days before or after the sale. If you do, you’ll add the loss to the cost basis of the replacement security.
There is no concrete definition of “substantially identical,” but there are some common interpretations when it comes to stocks. A company’s common stock and a call option on that stock are “substantially identical,” whereas ETFs that track similar indexes but are managed by different companies are not “substantially identical.”
Note that the Wash Sale Rule also applies to all your accounts, including IRAs and spousal accounts. So, you cannot simply repurchase the same security in your spouse’s IRA and maintain the same economic position as before!
A Quick Example
Suppose you bought 1 BTC for $50,000 on January 1. If the price of BTC falls to $40,000 by December 1, you could lock in your losses by selling and realizing the $10,000 loss. Then, you could use the $10,000 loss to offset other capital gains or income.
You could comply with the Wash Sale Rule in the above example by repurchasing a different crypto asset, such as Ethereum. While the two may be highly correlated, they are likely not “substantially identical;” therefore, the rule stands.
On the other hand, you could run into trouble if you repurchased Bitcoin futures or other investments that are essentially the same as Bitcoin.
A Crypto Loophole?
The IRS has not explicitly stated that the Wash Sale Rule applies to cryptocurrencies, which it treats as “property” rather than “securities” for tax purposes.
Theoretically, you could sell your BTC, claim the loss, and immediately repurchase it without violating the Wash Sale Rule. However, it’s crucial to note that this is a grey area, and the IRS could change its stance or retroactively apply the rule.
As a result, most experts recommend a conservative approach that assumes the Wash Sale Rule applies to cryptocurrencies.
Tax Loss Harvesting Tools
Selling losing positions to lock in losses is more complicated than it seems for crypto markets. For example, you might be tempted to sign in to Coinbase, look at your profits and losses, and sell the biggest losses to lock in profits.
However, if you purchased the same cryptocurrency on a different exchange or wallet, the gain or loss may not be entirely accurate in Coinbase. You must match each sale to a specific purchase depending on your accounting method,
Fortunately, ZenLedger can help streamline the calculation of profits and losses and identify opportunities to lock in losses.
ZenLedger provides various tools to help you comply with the IRS and minimize your tax obligations, including tax loss harvesting. Source: ZenLedger
After signing in, navigate to the “Tax” section and click “Tax Loss Harvesting” in the right column. You can then generate a spreadsheet containing your portfolio’s current tax loss harvesting opportunities.
ZenLedger’s TLH report shows you exactly what coins you need and how much to sell to lock in your losses. Source: ZenLedger
The spreadsheet has several tabs:
- Summary by FIFO. This summarizes the losses using the first-in, first-out accounting method (the most common).
- Summary by LIFO. This summarizes the losses using the less common last-in, first-out accounting method.
- FIFO Ordering of Sells. This shows you the crypto assets you own with an unrealized loss using the FIFO method.
- LIFO Ordering of Sells. This shows you the unrealized losses using the LIFO method.
Before taking any action, speaking with an accountant or tax professional is a good idea. You must use the same accounting method year to year when completing your Form 8949 or Schedule D. An accountant can help you decide on the best approach to take when selling coins to avoid violating the Wash Sale Rule.
ZenLedger also lets you see a holistic view of your crypto assets across wallets and exchanges and generate the tax forms you need each year. That way, you don’t have to worry about any year-end surprises and can track your tax obligations and estimated payments throughout the year to remain in compliance with IRS rules.
The Bottom Line
Most crypto traders and investors only pay attention to their wins, but locking in losses can significantly boost your after-tax returns. Fortunately, new tools make tax loss harvesting easier than ever despite the complexity crypto introduces.
When implementing tax loss harvesting, speaking with an accountant or other tax professional is a good idea to ensure you comply with the Wash Sale Rule and that the moves make sense, given your broader portfolio and tax situation.
If you trade crypto assets, ZenLedger can help you keep everything organized to simplify your life (and your accountant’s life). And, if you have a simple tax situation, you can complete your entire tax filing through our partnership with accountants.
Get started with ZenLedger today for free!
If you have any questions, contact our support team, who can steer you in the right direction.
This material has been prepared for informational purposes only and should not be interpreted as professional advice. Please seek independent legal, financial, tax, or other advice specific to your particular situation.
