In my latest conversations with private clients, the number one question I get asked is about tax loss harvesting (TLH). TLH is best thought of as purposefully selling an investment you bought that is currently below your purchase price to lock in a capital loss on your taxes.
Due to bitcoin’s regulatory classifications, there is a unique way to take advantage of tax loss harvesting that isn't possible with equities! One quick note, the following discussion of TLH strategy is solely based on U.S. tax laws, and this practice may or may not be possible in other jurisdictions.
Steven Lubka, a CoinDesk columnist, leads Swan Private, Swan Bitcoin's concierge service for high-net worth investors. This article is part of Tax Week.
Additionally, this does not constitute advice, and make sure to talk with your own CPA [certified public accountant] before making any tax decisions!
In the stock market, if you sell an equity and repurchase a similar instrument within 30 days any loss generated from the sale will be disallowed, meaning you can't use the loss to offset any other capital gains. This rule also applies in reverse.
This is due to something called the wash sale rule, however, the wash sale rule only applies to securities. Bitcoin is classified as “property” under the U.S. Internal Revenue Service (IRS) tax code and is exempt from the wash sale rule.
What this allows you to do is instantly sell and repurchase your bitcoin in order to lock in tax benefits. This is important because most investors don’t actually want to sell their bitcoin at these prices, they want to hold their bitcoin for its eventual recovery.
Selling bitcoin and having to wait over 30 days to buy it back could cause investors to miss out on a substantial price increase if it was done at the wrong time. This is why bitcoin’s tax classifications allow for a unique approach to managing any unrealized capital loss you may have on your bitcoin position.
See also: US Crypto Tax Guide 2022
During the time I have managed the Swan Private team for Swan Bitcoin, we have helped investors perform hundreds of tax loss harvest transactions while prices have been low, generating highly meaningful tax savings.
A capital loss can benefit
So why should you lock in a capital loss? Capital losses are a versatile tax tool that can help you save a significant amount of money on your EOY [end of year] tax obligations. There are two main ways a capital loss can help you, and one important detail to be aware of.
- A capital loss can be used to offset a corresponding amount of capital gains. These capital gains can include the sale of stocks, dividends from investments, the sale of real estate, the sale of rental property, the sale of startup equity and K-1 distributions. You can offset any amount of capital gains per year, up to the amount of the capital loss. The one restriction is long-term capital losses can only offset long-term capital gains, whereas short-term capital losses can offset either long term or short term capital gains.
- A capital loss will allow you to offset up to $3,000 of ordinary income per year. Ordinary income meas W-2 income, rental property income, 1099 income and other sources.
What happens if you don’t have enough eligible capital gains and ordinary income to use your entire capital loss? You can actually roll forward the capital loss to the next year – indefinitely. This means that even if you don't expect capital gains this year, but know you will have some capital gains in a future year, you can still take advantage of any capital losses this year to mitigate future tax events.
On a basic level, all that is required is a sale and repurchase of the bitcoin position. However, there are several other considerations to keep in mind.
Choosing an accounting method
Bitcoin investors can select three different accounting treatments for their bitcoin. These are Specific ID (HIFO, or highest in, first out), last-in first-out (LIFO), and first-in first-out (FIFO). Each of these methods refers to the question of “which” bitcoin was sold when an investor sells BTC.
For example, if someone had purchased 1 BTC on two different occasions and they then sell a bitcoin - which bitcoin was it that they sold? The one they bought at $10,000 or the one they bought at $60,000. You can see this obviously makes a big difference.
- FIFO: Any bitcoin sold is sold chronologically in the order in which they were purchased. The first bitcoin purchased is the first bitcoin sold. This method is generally best for people who started buying bitcoin when prices were high and kept buying as they fell.
- LIFO: Any bitcoin sold is sold in reverse chronological order. This method is generally best for people who started buying when prices were low and made their last purchase when prices were high.
- Specific ID (HIFO): Specifically select lots that are the highest cost and sell those first. It will usually allow the investor to lock in the largest capital loss possible regardless of when coins were purchased.
Why tax loss harvest your bitcoin?
Generally, the reason most people would take advantage of performing a TLH transaction is that they have some portion of their total bitcoin which is down more than 20%. Someone who is sitting on an unrealized capital loss of this magnitude or more, and who expects capital gains at some point in the future could benefit from taking advantage of the current low prices to lock in tax benefits for this year, or future years.
See also: Crypto Capital Gains and Tax Rates 2022 | (February)
Even if you don’t expect much in terms of capital gains anytime soon, the income deduction could also be one reason to perform a TLH transaction. This is particularly relevant for people who plan to hold their bitcoin for a long time, and potentially borrow against the bitcoin in the future instead of selling it.
If your goal is to sell your bitcoin quickly for a profit, you will end up resetting your cost basis when you do a TLH transaction which will net out any benefits accrued. However, if you have a longer investment timeline locking in losses today can be a good idea.