Is There a Bitcoin Tax Loophole? Crypto Can Be Used For Tax-Loss Harvesting, But Should You? Questions Answered

Last Updated on July 28, 2021

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Does Crypto, especially perhaps Bitcoin, help one exploit a tax loophole within the law? Or does it only help in evasion, assisting in a crime? Avoiding taxes, employing a tax loophole, shows that you’re smart. Or that you have retained smart people to work through these matters for you. Evading taxes, on the other hand, shows that you are a crook. 

The boundary between evasion and avoidance can be a tricky one, especially when the boundary questions involve a new and complicated asset class. This is a complicated multifaceted matter, with which the Internal Revenue Service itself has been struggling in piecemeal fashion. 

Mackenzie Sigalos, of CNBC, has contributed to advanced understanding in this field with an article on the consequences of the fact that the revenue code’s “wash sale” rules don’t apply to the Cryptocurrencies. 

What Are Wash Sale Rules?

Consider a simple example: one that involves plain old U.S. currency and an old-fashioned asset: corporate equity. Suppose two years ago you had purchased 100 shares of Microsoft stock. The stock in the meantime (in our hypothetical) has lost value. So by selling it when you do, you have a capital loss, not a gain. Not only will you not be taxed on any capital gain, but you can deduct your capital loss. Unless this turns out to be part of a loss sale. 

So let us suppose further that the next day, or any number of days later than your sale by less than 30, you buy 100 shares of Microsoft stock, re-establishing the same position in Microsoft you held before the sale. 

In this situation, the losses you took on your ‘first round’ with Microsoft are not considered losses at all. You cannot deduct them.

As Sigalos stresses, the “wash sale” rule seems not to apply to cryptos.  The wash sale rule is specifically for securities. Crypto is considered an asset, not a security. It is more like a Rembrandt painting than a block of MS stock. 

Tax Loss Harvesting
The first key point to draw from this is that crypto can be used for loss harvesting, without the encumbrance of that 30-day minimum period between transactions.

What is Tax Loss Harvesting?

The first key point to draw from this is that crypto can be used for tax loss harvesting, without the encumbrance of that 30-day minimum period between transactions. 

If you bought a block of bitcoin two years ago, and bitcoin tanked recently, to below the price at which you bought it, then by all means sell. Sell it all today. And use the cash gained from that sale to buy the same amount of bitcoin back tomorrow. You have locked in the tax loss. 

One wrinkle here is that in this situation the new “cost basis” for your capital holding will be the fair market value of the holding at the time of the sale, not the second-round purchase. The next time bitcoin falls below that cost basis, sell again. Rinse and repeat. 

Furthermore, even if your tax situation is such that tax  losses this year won’t help you in terms of the taxes you will pay for this year, you can carry the losses forward to future years, when they may help. And you can do that indefinitely. 

One obvious problem is that this loss-harvesting process requires very careful record keeping. The prices at which all purchases and sales are made have to be meticulously preserved. Without this, one cannot substantiate one’s calculations to the IRS. The harvesting will be for naught, and an eventual capital gain will be taxed in its un-cushioned ugliness. 

Final Thoughts

In general, investors in bitcoin, ethereum, dogecoin and the rest – some of which have seen significant dips (loss-harvesting opportunities) – can leverage their losses in ways that a typical investor in stocks or mutual funds cannot. There are pitfalls and difficulties, and you will have to talk this over with a CPA, tax lawyer, or other expert before putting it in operation.

We are not recommending or discouraging this loophole. But it is definitely worth a talk with your CPA.