Tax-loss harvesting could save you money as an investor if you’re trying to balance out capital gains with capital losses. But the IRS wash sale rule is designed to prevent people from unfairly taking advantage of tax-loss harvesting benefits. This rule applies to securities, meaning that cryptocurrency has been excluded as the IRS classifies it as property. But if a crypto wash sale rule were to take effect, that could have significant implications for digital currency investors.
A financial advisor could help you put together a tax strategy for your investment needs and goals.
What’s the IRS Wash Sale Rule?
The wash sale rule is an IRS guideline that specifies when and how investors can buy and sell securities to harvest tax losses. Tax-loss harvesting means selling assets at a capital loss to offset capital gains. This strategy is commonly used to minimize investment tax liability. When you deduct capital losses, you can offset up to $3,000 in ordinary income. Losses can be carried forward to offset future income for additional tax benefits.
Specifically, the wash sale rule prevents investors from selling a stock at a loss, then repurchasing a “substantially identical” asset in the 30 days before or after the sale. So you couldn’t sell 100 shares of XYZ stock on Monday, then turn around and buy 100 shares of that same stock on Tuesday and still be able to harvest any associated tax losses. The wash sale rule covers both taxable brokerage accounts and individual retirement accounts (IRAs).
In terms of when this rule kicks in, the wash sale rule applies to a variety of securities, including:
- Mutual funds
- Exchange-traded funds (ETFs)
- Stock warrants
The wash sale rule was created to discourage investors from selling securities at a loss for the sole purpose of claiming a tax deduction for the loss and gaining an unfair tax benefit. Any transactions the IRS deems to be a violation of the wash sale rule would not be eligible for any tax benefits associated with loss harvesting. In other words, you wouldn’t be able to deduct your capital losses which could mean paying more in taxes if you have significant capital gains for the year.
Does Wash Sale Apply to Crypto?
As of December 2021, there is no crypto wash sale rule in place–yet. The IRS officially considers digital currency to be property rather than a security. This means that you could technically sell cryptocurrency you own at a loss and repurchase the same cryptocurrency without having to observe any waiting period in-between. And you could claim capital losses or capital gains on your taxes accordingly.
That’s an advantage for cryptocurrency investors but there is something of a catch. This rule applies to cryptocurrencies that are not securities. It does not, however, extend to cryptocurrency stocks or funds, of which there are several.
So, say you purchased 100 shares of Coinbase (COIN), a stock that trades on the NASDAQ. You decide to sell the stock and do so at a loss. In order to harvest the loss, you wouldn’t be able to purchase a “substantially identical” crypto stock within the 30 days prior to and following the sale.
So what does substantially identical even mean?
The IRS doesn’t offer a straightforward definition. Instead, it’s left largely to investors to determine what substantially identical means, which can make tax-loss harvesting more challenging as there’s a lot of gray area to navigate. Talking to a financial advisor can help if you’re unsure which assets you can buy after selling securities to avoid a wash sale rule violation.
Could a Crypto Wash Sale Rule Happen?
Yes, it’s possible that cryptocurrency could eventually become subject to wash sale rules. The Securities and Exchange Commission is paying more attention to cryptocurrency and initial coin offerings (ICOs) and it seems likely that broader regulations will be imposed on both.
Meanwhile, the Build Back Better Act includes a proposal to subject cryptocurrencies to the wash sale rule. If the Act were to become law, cryptocurrencies would be subject to the same treatment as stocks, mutual funds and other securities when applying the wash sale rule. That means cryptocurrency investors could face new tax liabilities when selling crypto at a loss and buying new crypto assets.
If the wash sale rules were to be extended to cryptocurrency, that could happen sometime in 2022. That means crypto investors may not have much time left to take advantage of wash sale-free trading.
How to Avoid Wash Sale Rule Violations
Whether a crypto wash sale rule materializes or not, it’s important for investors to understand how to avoid wash sale rule violations. Otherwise, your best efforts at minimizing taxes with loss harvesting could come to nothing.
The simplest way to avoid overstepping wash sale rule boundaries is to pay attention to the timing. Remember, you’re barred from buying a substantially identical security in the 30 days before and after you sell them. So on the 61st day, you’d be clear to repurchase the securities without having to worry about the wash sale rule.
You could also avoid potential wash sale rule violations by being mindful of what you’re buying and selling. The IRS is fuzzy on what substantially identical means but it’s safe to say that buying the exact same stock or mutual fund would be considered identical. You may, however, be able to get around this rule if you’re trading one type of security for another. So you might sell off some of your energy stock holdings, for example, and replace them with an energy ETF.
Again, you may want to talk to a financial advisor or investment professional about what may – or may not – trigger the wash sale rule. This could be the safest way to avoid ending up with an unexpected tax bill.
Cryptocurrency can offer high profit potential for investors who are willing to accept greater risk in their portfolios. But it could also deliver a bigger tax bill in the future if cryptocurrency becomes subject to IRS wash sale rules. Staying up to date on crypto trends and tax law changes can help when it comes to managing your investment tax liability year to year.
Tax Planning Tips for Investors
- A financial advisor could help you figure out the potential tax implications of owning and trading cryptocurrency and what the extension of wash sale rules could mean for you. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Tax-loss harvesting is just one part of a smart tax strategy. There are other things you can do to keep investment taxes as low as possible, starting with the right asset location. Funding tax-advantaged accounts, such as a 401k or IRA, for example, can help to reduce your taxable income if you’re getting a deduction for those contributions. Meanwhile, you may be able to minimize taxes in a brokerage account by holding stocks and stock funds or tax-free municipal bonds. Using a capital gains tax calculator could help you to estimate what you might owe each year. The more proactive you are about managing taxes, the more you may be able to cut your tax bill.
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