What are the Risks of Crypto Tax Loss Harvesting?

November 5, 2022

What are the Risks of Crypto Tax Loss Harvesting?

There are risks involved in everything worthwhile in life. That is no exception when it comes to tax loss harvesting or getting some losses on paper for your crypto stock.

The Federal Reserve recently implemented tougher rules and significantly raised interest rates in an effort to reduce excessive inflation. As with almost all financial markets, rising interest rates and a deteriorating economic climate have had a negative impact on the crypto market.

The total market cap of all cryptocurrencies recently fell below $1 trillion for the first time since January 2021. Digital currency prices, such as Bitcoin and Ethereum, are at their lowest levels since 2020. Now that the market is in a bear market, it's time to use a strategy like crypto tax-loss harvesting. How would you go about doing so?

Let's get started!

What Is Tax-Loss Harvesting in Cryptocurrency?

Crypto tax-loss harvesting entails selling assets at a loss in order to offset the loss with capital gains from other investments. People who use this tax strategy can reduce the amount of tax they must pay.

You can reduce the amount of taxes you owe by selling assets for less than what you paid for them when you do crypto tax-loss harvesting. If you made any capital gains during the year, this can be beneficial. Remember that realized gains can be taxed. When you sell an asset at a loss, you receive capital losses that can be used to offset capital gains.

This tax strategy is frequently used by crypto investors at the end of a tax year or when the market has dropped significantly. If you use the right tool or piece of software, crypto tax-loss harvesting can help you pay less tax.

Is it legal to claim tax losses from cryptocurrency?

It certainly is! It is completely legal and does not constitute tax evasion. However, if you want to use crypto tax-loss harvesting correctly to reduce your income taxes for the year, you must follow certain wash sale rules.

It should be noted that rules like these can vary from country to country.

The Crypto Wash Sale Rule

To get the most out of the crypto tax-loss harvesting strategy, you must adhere to a crypto wash sale rule, which varies by country. This rule states that a taxpayer cannot deduct losses from the sale of a security or stock if they repurchase the same asset within 30 days.

This rule was enacted specifically to prevent taxpayers from selling assets in order to obtain tax breaks. Assume you earned a lot of money from your investments this year. If this is the case, you may discover that you have a large number of unrealized losses when you examine your holdings.

In this case, you could sell the cryptocurrencies to recover your losses. Then, before the value of the cryptocurrency rises, you could repurchase all of these currencies at a lower price. Because you used a wash sale, your capital losses aren't really losses because you put the money from the sale back into the same asset. Even if these losses aren't real, you can still use them to reduce your tax bill. Because of the ease with which crypto tax losses can be harvested, many tax offices have wash sale rules in place. An investor cannot profit from a wash sale under these rules.

Is Crypto Tax-Loss Harvesting Limited?

When you examine the tax laws of the United States, the United Kingdom, Canada, and Australia, you will notice that each country has different capital loss limits.

US Capital Loss Cap

In the United States, there is no limit to how much a capital loss can be used to offset a capital gain. However, if your total capital losses exceed your total capital gains, you must follow some special rules. You can only use $3,000 in capital losses to offset $3,000 in capital gains in this case. Any unused losses can be carried forward to the following tax year.

Canada Capital Loss Cap

Canada's capital loss rules are a little different in that you can only deduct half of your total capital losses. However, there is no limit to how much capital gains can be deducted. If you lose more money than you make in a given year, you can carry these losses forward indefinitely.

UK Capital Loss Cap

Everyone in the United Kingdom has a capital gains tax allowance of £12,300. If your capital gains exceed your tax allowance, you can use your capital losses to reduce your capital gains until they are less than the amount of your tax allowance. Right now, you can use as many capital losses as you want for crypto tax-loss harvesting.

Australia Capital Loss Cap

If you live in Australia, you can use capital losses to offset capital gains. This option is not restricted in any way. However, you must use all of your capital losses before carrying them forward to future tax years. This means you can't carry capital losses forward if you still have capital gains.

How Does Crypto Tax Loss Harvesting Work?

Cryptocurrencies are capital assets, which means they function similarly to stocks or real estate. You cannot profit or lose money by trading, selling, or spending cryptocurrency. Assume you own a cryptocurrency that has lost half of its value since the time you bought it. Until you exchange or sell your coins, this is not considered a loss in cryptocurrency.

By offsetting capital gains, crypto tax-loss harvesting is an effective method for lowering the amount of taxes owed on your annual tax return. Don't forget that you can still harvest even if you didn't make any capital gains this year. Finding additional losses can also assist you in lowering your taxable income or even canceling out profits from stocks or other types of assets.

As an example, wash sale rules already apply to stocks, bonds, ETFs, and other investments, so you can't simply take losses on paper and then immediately repurchase the position. However, you can do so right now in Crypto. You can sell a depreciated Bitcoin, accept the loss on paper while the market is down, trade it in principle, and then trade it back to Bitcoin and lose nothing except transaction costs. You lose thousands of dollars in paper with those transaction costs. However, Congress may reject washed-out rules and make the decision retroactive. Take note that this is a risk!

The Benefits of Crypto Tax Loss Harvesting

The primary benefit of the crypto tax loss harvesting strategy is that it allows you to lower your capital gains taxes. You may also be eligible for additional benefits depending on your country.

You may, for example, be able to deduct some of your capital losses from your income, putting you in a lower tax bracket. If you switched to a lower tax rate, your tax bill would be significantly reduced. However, keep in mind that crypto tax-loss harvesting does not guarantee that you will never have to pay capital gains taxes again.

This technique's goal is to postpone these taxes. You will have more money to invest in cryptocurrency each year if you postpone your capital gains taxes. By offsetting capital gains, crypto tax-loss harvesting is an effective method for lowering the amount of taxes owed on your annual tax return. Don't forget that you can still harvest even if you didn't make any capital gains this year. Finding additional losses can also assist you in lowering your taxable income or even canceling out profits from stocks or other types of assets.

To connect with one of our tax professionals, schedule a FREE 1:1 session here.

The Drawbacks and Risks of Crypto Tax-Loss Harvesting

This tax strategy can be very beneficial, but there are a few potential drawbacks. Tax officials will not come to check on you if you follow the rules regarding wash sales. However, if you frequently buy and sell cryptocurrency, your transaction fees will mount. Each transaction can cost up to 4% in fees, depending on the exchange. If you want to be certain that you're actually saving money, you should factor in these fees when calculating how much crypto tax-loss harvesting will reduce your tax bill.

As previously stated, harvesting your crypto tax losses does not eliminate your capital gains. These gains will still have to be taxed at some point in the future. When you sell back-bought crypto assets, you must pay capital gains taxes. If you buy cryptocurrency at a much lower price due to the recent drop, your capital gains may be much larger than you anticipated. Depending on the size of these gains, they may cancel out the tax savings you received from using this strategy in the first place.

Should You Try Tax-Loss Harvesting with Crypto?

Although crypto tax-loss harvesting should not be used on a regular basis, a drop in market conditions is the ideal time to use this tax method. Using your unrealized losses in this manner can help you avoid paying immediate capital gains taxes. This strategy can help you keep your assets intact while the market is down. There aren't many issues with implementing this method because cryptocurrency sales in the United States are exempt from the wash sale regulations. If you decide to use this strategy, be sure to consult some of the previously mentioned resources to avoid costly mistakes.

We hope you found this information useful! Please contact us if you have any questions. We'd be delighted to speak with you.

To connect with a tax professional, schedule a FREE 1:1 session here.

Final Thoughts

Crypto tax-loss harvesting is a great way to save money on taxes because it allows you to postpone paying capital gains taxes until later. Now that the market has entered a bear market, it is time to employ strategies such as crypto tax-loss harvesting.

Being audited is comparable to being struck by lightning. You don't want to practice pole vaulting in a thunderstorm just because it's unlikely. Making sure your books are accurate and your taxes are filed on time is one of the best ways to keep your head down during tax season. Check out Vincere's take on tax season!

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This post is just for informational purposes and is not meant to be legal, business, or tax advice. Regarding the matters discussed in this post, each individual should consult his or her own attorney, business advisor, or tax advisor. Vincere accepts no responsibility for actions taken in reliance on the information contained in this document.

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