Why tax season can add to the rout in Bitcoin, cryptocurrencies

Starting in 2022, the Internal Revenue Service (IRS) is expected to close a long-standing tax loophole that allows cryptocurrency investors to harvest their losses to offset their tax burden.

Digital coins, already under heavy selling pressure as the holidays approach, are being hit by wealthy investors fearing a stricter tax regime next year. The narrowing loophole could make matters worse.

Following a “rally of relief” after the Federal Reserve’s policy move, cryptocurrencies have been hammered along with stocks as the Omicron variant fears it will take hold of the markets again. While short-term volatility has come to define crypto trading, year-end fiscal positioning may also play a role.

Buying high and selling low is not an ideal investment strategy, but with crypto there is a silver lining. Savvy investors can take advantage of their tax returns by selling their crypto at a loss and then buying it back soon after.

The wash sale rule is used to tax capital gains on stocks, bonds and other financial securities, but not on cryptocurrencies. This loophole is one of many positions that could be closed by the Build Back Better bill pending in Congress.

Jordan Bass, a chartered accountant (CPA) and tax lawyer, told Yahoo Finance that the 30-day wash-out sell rule has never applied to crypto assets that are not distinctly classified as securities.

This allowed savvy investors to sell their “underwater” positions, use the loss to offset income taxes or other capital gains, and then redeem the position at a lower cost in a short period of time. of time.

For example, if a person takes a position of $ 10,000 in a crypto asset, the price of that crypto asset drops 75% to $ 2,500, that person can sell their asset at a loss of $ 7,500 – and use the loss to offset its total tax payable. .

With the cryptocurrency market being very volatile, investors can quickly buy back any coin of their choice for $ 2,500 at a lower tax rate, and sometimes get their entire position back.

Once executed, they can use their capital loss to offset other taxable gains or income per year up to a maximum of $ 3,000 under the rules. The balance can be carried forward indefinitely to future tax years. For large investment portfolios, the bottom line can make a huge difference. Tactics are a well-worn strategy for billionaires.

According to Bass, a number of his clients reaped crypto losses for tax purposes, particularly as the asset class’s previous bear market began in 2018.

“Investors can do it in crypto at least for the rest of the month. They can’t do that in the securities business. Brokerage accounts track this information and report it back to 1099 with adjustments based on the wash sale rule, ”Bass explained.

The lawyer also admitted that the harvest of tax losses was less ideal during boom times such as most of 2021, at least for “blue chip” crypto units such as Bitcoin (BTC-USD) and Ethereum ( ETH-USD). However, even these cryptocurrencies saw significant, albeit temporary, declines throughout the year.

The strategy is particularly useful for day traders who accumulate significantly more taxable events than a standard buy and hold investor. Bass admitted that some newer clients in the cryptocurrency markets had in fact had to pay more taxable income than the value of their total crypto holdings on tax day.

Don’t try it with an NFT

While investors may attempt to reap tax losses throughout the year, this is often contemplated and executed at the end of the year, according to Andrew Gordon, lawyer and CPA at Gordon Law.

He told Yahoo Finance that a number of his firm’s clients have used the method this year, particularly with their holdings of non-fungible tokens (NFTs). And the method is not for the faint of heart, as many investors often miss or misunderstand the rules, Gordon explained.

The IRS’s “economic substance” doctrine explicitly prohibits a filer from reporting a loss that has no economic impact. This means that investors cannot just sell their crypto and then buy it back at the same price and write it off as a loss. Moreover, they cannot do this with an NFT, whose selling point is its uniqueness (hence the “non-fungible” in NFT).

“For Bitcoin or Ethereum which are fungible, it doesn’t matter what coin you have, it’s the same. This is not true for NFTs. You usually can’t sell and redeem the same – and if you are, then maybe the entire sale is a sham, ”Gordon said.

“We’ve seen people ‘sell’ to their friends and then buy it back or they buy it back very immediately at the same time,” Gordon said. “This will not be accepted by the IRS.”

As the 30-day wash-out sell rule applies next year, Gordon pointed out that investors can still recognize losses from underperforming crypto assets, scams or “carpet draws” as they hope. never buy back these same assets.

On the flip side, the reverse “collect taxes” maneuver, often favored by high net worth investors, also contributes to the selling pressure around crypto and other assets like stocks, according to Gordon.

He said many of his clients with large holdings were also selling their earnings now before a stricter U.S. tax regime took hold next year.

David Hollerith covers cryptocurrency for Yahoo Finance. Follow it @dshollers.

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