The House Ways and Means Committee tax proposal unveiled last month has two provisions to shutter lucrative crypto tax loopholes. These are the subject of today’s blog post: the “wash sale” rules and the “constructive sale” rules, both contained in the Internal Revenue Code at Sections 1091 and 1259, respectively.
First let’s discuss the so-called “wash sale” rules. Given the volatility of the crypto market, the fact that the wash sale rules do not on the face of the statutory language apply to crypto transactions, means taxpayers can “harvest” significant tax losses that will offset other income on the US tax return.
Here is how it works – A taxpayer can sell crypto that is trading at a loss from the time of initial purchase, capture the loss for US tax purposes and then buy the crypto right back. No need to wait and risk further market changes. If the taxpayer does not have enough capital gains to use the losses in a tax year, the losses can be used to offset $3,000 of that year’s ordinary income. In addition, unused losses can be carried forward to later tax years. Piling up these losses is how the savvy crypto investor ultimately offsets future gains on the crypto while also having an opportunity to lower the capital gains tax that would apply on sales of other capital assets (e.g., stocks).
What is a “wash sale”? A wash sale occurs when a taxpayer incurs losses on a stock or security, but within the time frame of 30 days before or after that sale, the taxpayer purchases the same or a substantially identical stock or security. The wash sale rules, discussed below, are designed to discourage taxpayers from selling securities at a loss simply in order to claim a tax benefit.
The wash sale rules apply to losses incurred on a sale of “stocks or securities” under the rules contained in Internal Revenue Code Section 1091. If the rules apply, the losses are disallowed, but the disallowed loss can be added to the cost “basis” of the newly purchased stock or security. In essence, the taxpayer is forced to wait until a later disposition of the new stock/security to use that loss. This adjustment simply “postpones” deducting the loss. The taxpayer’s holding period for the new stock or securities includes the holding period of the stock or securities that were sold. The Internal Revenue Service provides an informative page on the wash sale rules, here.
Here’s an example: Assume that you purchase 100 shares of Stock A for $10,000 on March 1st, 2020. You hold the shares for over one year, and on January 8th of 2022, you sell them for $6,000. That would create a long-term capital loss of $4,000.
If instead, you repurchased 100 shares of Stock A two weeks after the sale at a cost of $7,000, you would not be able to deduct the $4,000 capital loss due to the wash sale rules. Instead, that $4,000 loss would be added to the basis of the new shares you purchased, for a cost basis in the new Stock A shares of $11,000.
If you substitute Bitcoin for Stock A in this example, the $4,000 loss would be deductible even though you repurchased new Bitcoin two weeks after the sale. This is because the wash sale rules do not apply to crypto. Why? A technical glitch in the law that the House Ways and Means Committee seeks to fix, as discussed below. The glitch involves the fact that the Internal Revenue Service has classified such virtual assets as “property” rather than as “securities” making Section 1091 inapplicable on its face.
For those with an interest, a lot more detail on the US tax treatment of crypto is at my blog post here.
House Ways and Means Committee Proposals
The proposed legislation of the House Ways and Means Committee would expand application of Code Section 1091 wash sale rules to “digital assets,” such as cryptocurrencies. Harvesting tax losses from crypto trades would thus be significantly thwarted. If enacted, these amendments would apply to sales occurring after December 31, 2021, and could reportedly raise up to $16 billion tax dollars over the following 10 year period.
Crypto investors with losses should take advantage of this narrow window of opportunity. Crypto prices have fallen from a record in May, so for many, the time is now. December 31 is the use-by date!
An administrative nightmare also looms for crypto investors. It will be extremely difficult for investors to keep track of their purchases and sales and avoid violating the wash-sale rule. Virtual coins and tokens are often purchased on centralized and decentralized platforms that don’t keep track of the purchase and sale of assets in the same way as a brokerage firm or mutual fund. It will be a messy situation and means that crypto investors will have to keep very careful track of their basis and adjustments.
In another bid to undermine the tax benefits of crypto, the House Ways and Means Committee tax proposal unveiled last month contains changes to Internal Revenue Code Section 1259 “constructive sale” rules. Under current law, the Code provides that a sale is deemed to occur when a taxpayer engages in certain transactions (for example, entering into a hedge or a swap transaction that involves the same or identical appreciated stock/debt/partnership interests that the taxpayer currently holds). In other words, the tax law “pretends” a sale has taken place when the taxpayer adopts certain offsetting positions to previously owned positions. The taxpayer must report this pretend “sale” of the previously owned position on his tax return accordingly. These rules prevent taxpayers from locking in investment gains without realizing taxable gain.
The proposed legislation would expand the reach of Section 1259’s constructive sale rule to also apply to transactions involving specified digital assets, including cryptocurrency. Thus, for example, an investor that owns $100,000 of Ethereum that was acquired at a cost basis of $30,000 would recognize $70,000 of gain, if the taxpayer entered into a short sale transaction involving Ethereum.
Posted October 14, 2021
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2 thoughts on “Crypto – Harvest Your Tax Losses / Use Offsetting Positions While You Can – Deadline 12/31”
We have had many discussions / arguments internally whether IRS will eventually take a position that crypto is or is not a “security” for federal income tax purposes. Even if the House bill on wash sales does not get enacted, there is still a major issue there. Has lots of implications.
If crypto IS a “security”, then it gets covered by wash sale rules and Section 1259 “short against the box” gain recognition. On the other hand, non-US persons could then trade crypto using an advisor located in the US without being engaged in trade or business in the US, because the 864 “trading for one’s own account” rule would apply. And dealers could elect to mark their crypto portfolios to market annually under Section 475 if crypto is a security. Some of those raise revenue. Some lose it. Eventually the IRS will face a case where they have to come down on one side or the other.
Anyway, once again you have your finger on the pulse of evolving areas of US tax law.
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Thank you, Richard for this wonderfully informative comment. Yes, the issue whether crypto will be classified as a “security” has so many implications. It’s daunting! And of course, I appreciate your constant encouragement and kind words about my blog.
Wishing you all the best, Virginia