The Wash Sale Rule and Tax Loss Harvesting for Crypto
Insights | by Sharon Winsmith
While we wait out this prolonged bear market for crypto, it might be a good time to consider doing some tax loss harvesting before year-end. Tax loss harvesting might be a great way to reduce your taxes for the year by generating capital losses that can offset capital gains.
What Is the Wash Sale Rule?
The wash sale rule prevents an individual from selling a security at a loss and then, within 30 days before or after the sale, buying that same security, or a substantially similar security. That means there is a 61-day window where you cannot buy the same investment, or a substantially similar investment. If you violate the wash sale rule, you are not allowed to claim the loss on your tax return.
We typically think of the wash sale rule as applying to publicly traded stocks.
The purpose of the rule is to prevent individuals from recognizing a loss for tax purposes while still maintaining the position in the security. The price of stocks is highly volatile. Therefore, the IRS wants to prevent people from manufacturing losses by selling shares when the market is down without really disposing of the investment itself.
The rule also applies to certain related parties or entities owned by the same person or a related person. You are not able to circumvent the wash sale rule by using a different entity or having your spouse buy the same stock you just sold.
What Happens If You Violate the Wash Sale Rule?
If you purchase a security in violation of the 61-day window, you are disallowed from claiming the loss you realized from the sale on your tax return for that year.
Instead of claiming the loss, you will increase your cost basis in the new security by the amount of the disallowed loss. This means the loss is preserved by an increase in your basis so that you can claim the loss when you sell the stock in the future in a transaction where the wash sale rule does not apply.
An Example of the Wash Sale Rule
Let’s look at a quick example of how the wash sale rule works in practice.
Jane buys 1 share of Apple (AAPL) stock on January 1 for $100. Jane’s cost basis in the Apple stock is $100.
On April 1 of the same year, Jane notices the price of Apple shares have dropped to $75 per share. Jane would like to keep owning her Apple share; however, she thinks it might be nice to have a $25 capital loss to claim on her tax return.
If Jane sells the Apple share on April 1, the wash sale rule will apply if Jane buys another share of Apple at any time between the dates March 2 and May 1.
Let’s say Jane didn’t know about the wash sale rule and bought 1 Apple share back on April 15 for $80.
Jane is not allowed to claim the $25 loss she realized from selling her share on April 1 on her tax return. Rather, Jane’s new basis in the 1 Apple share she owns is $105 [$80 cost basis for the share purchased on April 15 + $25 loss disallowed from the share sold on April 1].
Does the Wash Sale Rule Apply to Crypto?
No. Under current law, the wash sale rule does not apply to cryptocurrency. That means if you sell crypto, there are no restrictions on when you can buy the same crypto back.
As presently defined, the wash sale rule applies to “shares of stock or securities.” Although the IRS has clarified that cryptocurrency is considered “property” for purposes of applying the tax rules, crypto is not considered to be a “security” within the meaning of the wash sale rule.
Why does this matter?
This can create huge tax savings opportunities if you own crypto that has dropped in value since you purchased it. These savings can be recognized by doing tax loss harvesting (discussed more below). Given the prolonged crypto winter we find ourselves in, there could be a good number of people who have a net loss in some or all of their crypto holdings.
Potential Law Changes to the Wash Sale Rule for Crypto
It is probably only a matter of time before Congress will pass a law change applying the wash sale rule to cryptocurrency. Most believe this is inevitable.
All Congress has to do is include cryptocurrency within the definition of “securities” for purposes of applying the wash sale rule or expand the wash sale rule to specifically apply to cryptocurrencies. This means you better act fast, because this loophole could be shut down at any time.
Tax Loss Harvesting
As investors, we typically don’t want to sell an investment when the price is less than what we originally paid for that asset. That would mean we lost money on the investment. Tax loss harvesting, if done right, can allow you to take advantage of tax losses on your return without really disposing of the investment itself.
What is Tax Loss Harvesting?
Tax loss harvesting is when you trigger losses in your investment portfolio to offset other income. Thereafter, you reinvest the money back into a similar investment or other asset to keep the money invested.
In essence, you are generating a capital loss while still holding an asset. That capital loss can then offset capital gains or other income (up to $3,000) for tax purposes in the same tax year.
These are the steps for tax loss harvesting:
- Step 1: Buy an asset
- Step 2: Sell the asset for a loss when the value decreases below your basis
- Step 3: Purchase a similar asset or different asset that meets your investment objectives
- Step 4: Recognize the capital loss on your tax return
The problem is that the wash sale rule makes it difficult to do tax loss harvesting. That means tax loss harvesting can only be done if you: 1. acquire a replacement asset that is substantially different from the one you sold, OR 2. do the harvesting with an asset the wash sale rule doesn’t cover.
There is even now software available, like Wealthfront, that will automatically do tax loss harvesting for you. The jury is still out on whether these automated trading tools really do improve your results.
Example of How Tax Loss Harvesting Works
Let’s look at an example of how tax loss harvesting can work in practice.
Bill owns 100 shares of Coca-Cola (KO) he purchased at $10 per share. Bill’s cost basis in the shares is $1,000.
On December 15, Bill notices the price of Coca-Cola shares has dropped to $7 per share. Bill sells the 100 shares for $700 and recognizes a $300 capital loss.
Bill thinks the soft drink industry has huge upside potential in the next few months and he wants to keep owning shares in a soft drink company. Bill can’t buy back the Coca-Cola shares because the wash sale rule would mean he couldn’t claim the $300 loss on his tax return this year. So what can Bill do?
Bill can buy shares in a competitor to Coca-Cola, like Pepsi (PEP). So Bill takes the money from the sale of the Coca-Cola shares and immediately buys shares in Pepsi.
There are several benefits to Bill’s approach:
- Bill generated a $300 capital loss that can offset capital gains or other income for the year
- The wash sale rule will not apply to disallow the loss because Pepsi and Coca-Cola shares are substantially different enough as they are two completely separate companies
- Bill continues to participate in any upside appreciation in the soft drink industry because he owns Pepsi shares
Common Ways to Harvest Tax Losses and Avoid the Wash Sale Rule
There are a number of strategies taxpayers have used to harvest tax losses in a way that avoids triggering the wash sale rule. Here are a few examples of the most common strategies.
- Buying shares in a competitor company: The Pepsi and Coca-Cola example are the most commonly used competitors to illustrate how this works. Both companies produce very famous lines of soft drinks. However, they are two different companies with different products, management teams, employees, etc. Therefore, they are not substantially similar enough to violate the wash sale rule.
- Trading actively managed mutual funds: Many mutual funds invest in the same or similar assets. However, mutual funds that are actively managed have different management teams, each with their own strategy. Therefore, you can often sell one actively managed mutual fund and purchase another with a similar investment philosophy without tripping up the wash sale rule.
- Trading into index funds: You typically can’t sell one index fund and buy back another index fund that tracks the same underlying asset(s). However, you can buy an index fund after selling shares of stock in specific companies. This might be a good approach when the S&P 500 is down across the board.
- Buying different asset classes: There is no rule that says when you sell one type of asset you have to buy another asset back in that same asset class. This could be a good approach during a recession when all asset classes are down across the board. You could sell stock and buy real estate and still participate in appreciation as all markets recover over the next few years.
Risks of Tax Loss Harvesting
Tax loss harvesting seems like a great tax savings strategy. However, there are a number of issues you should be aware of before attempting to implement this yourself.
- Not all companies are equal: Selling shares in one company and buying shares in another company are not the same investment. Coca-Cola and Pepsi are two very different companies. It is possible that the price of one stock could increase while the price of the other stock decreases.
- Not all investments are equal: Similar to the logic above, a different investment may not have the same return as the investment you sold. Moving between asset classes when you do tax loss harvesting might not always lead to the result you were hoping to get.
- What losses say about your overall investment strategy: Tax loss harvesting means you have an investment with a loss. Yes, there will always be times when the market is down. However, perhaps it is a good time to re-examine your portfolio to see whether you are beating the S&P 500 index funds.
- Abuse by financial advisors: Financial advisors often use tax loss harvesting as a way to justify their fees. They may tell you things like “everybody does tax loss harvesting” or “it’s time to rebalance your portfolio.” However, it might be time to reconsider if using an investment advisor to cherry pick investments vs. passive investments in index funds makes sense.
The best time to do tax loss harvesting is in a down market.
Tax Loss Harvesting for Crypto
Now is a great time to consider doing tax loss harvesting for crypto. Crypto is a prime candidate for tax loss harvesting for a number of reasons:
- The wash sale rule does not currently apply to cryptocurrencies
- You can immediately purchase back the exact same type of crypto you sold
- Crypto prices are highly volatile and there are usually many opportunities to sell at a loss
- The prolonged crypto winter and recent events have led to significant decreases in crypto prices
The best time to do tax loss harvesting is in a down market.
When selling the shares, you want the capital loss generated to be as high as possible. That means the best day to sell is the day where the price is the lowest.
How to Do Tax Loss Harvesting for Crypto
Tax loss harvesting for crypto is easy. You just need to sell the crypto on an exchange and then immediately buy that same crypto back.
There will likely be exchange fees or gas fees that apply when you sell the crypto and when you buy it back. That means you may not be able to buy back exactly the same amount of crypto you sold. However, the difference should be negligible.
Make sure the cost of the fees does not exceed the tax benefits. If the tax benefits from the capital losses you generate do not exceed the trading fees, it probably isn’t worth the effort.
Risks for Tax Loss Harvesting for Crypto
While doing some tax loss harvesting for your crypto portfolio might be a great idea, there are some risks you should be aware of before making any trades.
- Exchange and gas fees: Trading fees can be high. Make sure the tax benefits more than exceed any costs from selling and buying back the crypto.
- Potential for retroactive law changes: There is always a possibility that Congress could pass a law change that applies the wash sale rule to crypto. It is also always a possibility that Congress could make that law change retroactive which could mean you can’t claim the loss on your tax return even if you do the tax loss harvesting while the loophole remains open. If this happened, the risk to you would be the fees you paid from the trades.
Nothing contained in this article constitutes investment advice. Rather this content is intended to be educational and used for information purposes only. You are strongly encouraged to do your own independent research and work with your advisors before making any investment decisions.