How to strategically handle losses on your tax return
Cryptocurrency has been a more volatile investment than the stock market over the past few years. For example, in November 2021, the cryptocurrency market hit its peak at $3 trillion, and then two months later, plummeted 40%. It still hasn’t recovered its market capitalization, and as of Aug. 18, 2022, it’s at a little over $1 trillion.
If you’ve been riding the cryptocurrency wave and bought/sold any this year, you will have to pay the taxes on it if you made a profit or on the other hand, strategically harvest the capital losses.
Capital losses are the losses investors assume when selling an investment for less than they paid for it. In down years, you may be able to use your loss to lower your tax liability and better position your portfolio going forward. This strategy is called tax-loss harvesting.
The taxpayers’ capital losses can offset up to $3,000 of their ordinary income, and additional losses can offset capital gains. Unfortunately for cryptocurrency investments, this process isn’t so easy.
The problem cryptocurrency investors are running into right now is most companies do not have a good reporting mechanism to provide accurate documentation to taxpayers, says Senior Tax Research Manager Yunnice Chang.
“Stock is heavily regulated, and there is an industry standard in reporting transactions, including profit and losses,” Yunnice said. “The challenge we are seeing is the cryptocurrency market isn’t really regulated in the U.S., so the mining companies that are supposed to keep track of and report transactions aren’t keeping track very accurately, if at all.”
Investors who are used to getting the typical 1099 with a report of all their transactions are not seeing those from cryptocurrency providers. Some have to rely on their own notes they took in an excel sheet about their transaction history.
Recordkeeping is essential to keep track of the cost basis, or purchase price, of your prior investments. Third parties like Koinly allow taxpayers to keep track of their cryptocurrency investment transactions. Services like this one claim to create tax forms in a matter of minutes for a fee.
Although the IRS hasn’t issued much guidance on handling cryptocurrency, it has determined that it is a property and not a security for federal tax purposes.
“Cryptocurrency is a virtual currency that is categorized as a property, unlike stock investments, which the IRS considers a security,” Yunnice said. “This means it has similar tax implications, but are not the same.”
Importantly, the wash-sale rules that normally apply to stock purchases don’t apply to cryptocurrency purchases. The wash-sale rule disallows your loss if you acquire substantially identical securities within the 61-day period beginning 30 days before the date of the loss sale and ending 30 days after that date.
So, investors can sell their cryptocurrency for a loss, lock in the loss amount to apply to the taxpayer’s other capital gains, and then purchase the same cryptocurrency at a reduced rate sooner than 30 days.
“This may be an opportunity for some taxpayers,” Yunnice said. “But, with the market volatility right now, it’s still a gamble. You may sell your crypto and lock in a loss, then a few days later go to purchase it back, and it be a much different price.”
Once you’ve sold and locked in your loss, the investor needs to determine if it’s a short-term or long-term capital loss.
“Your tax preparer or CPA can help you determine which cost basis method would be best to use to harvest your losses,” Yunnice said. “There are different tax implications for short-term and long-term capital losses and other factors to consider as with any investment.”