If you’re an investor looking to offset your capital gains with capital losses, you might be able to save money by harvesting tax losses. However, the wash sale regulation of the Internal Revenue Service ensures that no one unfairly takes advantage of the tax benefits of loss harvesting. Since the Internal Revenue Service considers cryptocurrencies to be property rather than securities, they are exempt from this regulation. For this reason, implementing a crypto wash sale law might have far-reaching effects on the cryptocurrency market and investors.
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What Is a Wash Sale?
When an investor sells losing security to take a capital loss and does not hold onto the security for at least 30 days before or after the sale, the sale is considered a wash sale.
Investing in a similar security, making a taxable acquisition of a similar security, or gaining a taxable option to invest in a similar security.
Some traders expect that by employing this strategy, they can reduce their taxable income without completely removing themselves from the security market.
The IRS put the Wash Sale Rule to prevent anyone from selling a security at a loss to take a tax write-off. It is against the rules to sell a security and then repurchase it or acquire an option to repurchase it within 30 days of the sale. The regulation does not forbid the sale but prevents the investor from taking a tax deduction for the loss.
The phrase “substantially comparable” was not defined by the IRS in the regulation. Consequently, investors who wish to prevent a wash sale must consult the different decisions and letters issued by the IRS throughout the years. The facts and circumstances testing is one of the most valuable tests since it requires the investor to take into account all of the relevant factors to conclude whether or not the securities in question are, in fact, substantially comparable.
The restriction doesn’t outright ban a sale but prevents the investor from deducting the loss on their taxes.
The term “substantially comparable” was not defined by the IRS in the regulation. Therefore, investors who wish to prevent a wash sale must refer to the many rulings and letters issued by the IRS throughout the years. The facts and circumstances test are one of the more practice tests. It indicates that the investor should consider all relevant facts and circumstances to establish if shares are substantially comparable.
For tax purposes, the Internal Revenue Service does not consider bonds, preferred stock, or bonds of one corporation to be substantially similar to the common stock of another corporation.
How about the Wash Sale Rule—Does it Work with Cryptocurrency as well?
Currently, cryptocurrency holdings are considered property rather than securities by the IRS. So, technically, the wash rule now does not apply to cryptocurrencies. To minimize their taxable profits, many crypto investors use a tax strategy known as “tax loss harvesting,” which involves selling assets at a loss.
However, cryptocurrency regulations are continually evolving. There has been talking of prohibiting “wash trading” in cryptocurrencies as soon as possible.
In 2021, the House Ways and Means Committee and the Biden administration each proposed legislation that would apply wash sale regulations to digital assets. These developments demonstrate the government’s commitment to the issue, even if the Build Back Better measure did not pass Congress.
Using Crypto Tax Loss Harvesting Instead of Crypto Wash Sales
After 30 days, it is no longer considered a wash sale to repurchase a cryptocurrency.
Gaining access to losses in a cryptocurrency can be done in more secure methods. One way to avoid a wash sale is to exchange the depreciated asset for a currency whose value is highly tied to its own. After 30 days, you will have to sell the associated coin and repurchase the original investment. For instance, you may sell your BTC in exchange, wait through the wash sale period, and then buy back your BTC.
Can You Avoid the Wash-Sale Rule?
There are easy strategies that traders can use to avoid selling a security before the wash-sale period has ended. Suppose an investor wanted to keep some of their money in the technology sector after selling 100 shares of XYZ tech stock on December 15. In that case, they could invest in a technology exchange-traded fund (ETF) or tech mutual fund instead of stocks.
Due to the inherent differences between the financial instruments employed, this method cannot produce an exact reproduction of the starting position. After 30 days, the investor may sell the ETF or mutual fund and reinvest the proceeds in XYZ stock if they choose. While it is possible to repurchase equities within the 30-day window, doing so will prevent the investor from taking a tax credit for the first loss.
Buying more stock and holding it for 31 days is another straightforward way to sidestep the rule’s impact. After that, the investor can sell the worst-performing shares and take a tax hit in the amount of the loss.
You can’t sidestep the rule’s effects by buying in one account and selling in another, so keep that in mind. Each investor, rather than each account, is subject to the rule. In other words, the Wash Sale Rule will apply if an investor incurs a loss on the sale of an asset in one account and then, within 30 days before or after the sale, buys the same or substantially similar security in another account. For wash sales involving multiple accounts, investors must file a separate report with their broker.
It is also not possible for an investor to sidestep the rule’s effects by having one spouse sell and the other buy. The IRS won’t approve the deduction since they treat married couples as single entities. An investor’s own company is subject to the same regulation. One sales unit will account for the exchange between the company and the investor. The loss will not only be disallowed if the investor repurchases the assets within an IRA, but the investor’s cost basis for the shares will also be unaffected.
When engaging in year-end tax-loss harvesting, it is crucial to keep in mind the implications of the Wash Sale Rule. If you sell equities by December 31 to take advantage of a tax loss, you cannot repurchase them until at least January 31 of the following year.
The last point is that investors cannot get around the restriction by acquiring assets only to sell them at a loss within 30 days. Under the Wash Sale Rule, it makes no difference what sequence the purchase and sale occur. For tax purposes, a loss is disallowed if followed by or occurs within 30 days of acquiring the same or substantially comparable security.
The Penalty for a Wash Sale
The act of conducting a wash sale itself is not forbidden by law. However, claiming the tax loss on a wash sale is unethical. No matter how many wash sells a trader or investor makes in a given year, the IRS will not care. However, losses from sales occurring within 30 days of the purchase will be disallowed.
The IRS will deny the original loss deduction if it is determined that the transaction breaches the Wash Sale Rule. The loss will be deducted from the cost basis (the initial acquisition price for tax purposes) of the security. When calculating capital gains, the IRS includes the holding term of the sold security in the holding period of the newly acquired security.
The “penalty” of repurchasing securities may have some upside if the loss on the resold investment is more significant than the original loss. Just as a short-term loss or gain can become a long-term one with the right amount of holding time, so can the opposite. However, taking a loss on the original sell is strictly prohibited at now.
Conclusion
The Wash Sale Rule was established by the Internal Revenue Service to discourage investors from unnecessarily selling shares to reinvest the proceeds as a tax loss.
For those who can handle a higher degree of uncertainty in their financial holdings, cryptocurrency investing can be a lucrative option. However, if the IRS decides to apply wash sale regulations to cryptocurrencies, this might lead to a larger tax bill in the future. To better manage your investment tax burden from year to year, keeping up with the latest developments in the crypto space and any changes to applicable tax laws is essential.
FAQs
When a taxpayer sells a cryptocurrency at a loss and then repurchases the same or a nearly similar asset within 30 days of the transaction, this is referred to as a crypto wash sale. The wash sale rule prevents the sale’s loss from being tax deductible. This implies that the person cannot deduct the amount of the loss from their taxable income, resulting in a greater tax burden.
The wash sale regulation is meant largely for stocks, but it also applies to cryptocurrency. While participating in crypto wash sales is not unlawful in terms of itself, doing so for the express aim of lowering your taxes may violate tax laws and regulations. It is best to consult a tax specialist to ensure that your crypto transactions are in accordance with local tax rules.
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Source: Investopedia, TokenTax