Tax Loss Harvesting is a strategy that might be able to help you reduce your crypto taxes. It works by selling an asset when it is in a loss, and buying back a similar asset to maintain exposure to its price.
Tax Loss Harvesting is best highlighted with an example:
Crypto Tax Loss Harvesting Example
CZ has a $10k taxable gain on crypto this year, but his portfolio is down. He wants to reduce his gains So he considers a tax loss harvesting strategy.
He bought 10 BNB for $500 each = $5000 cost basis
BNB drops to $250 and he has a $2500 unrealized loss.
He sells his 10 BNB at a $2500 and locks in the $2500 loss.
By realizing the loss, he has reduced his capital gains for the year from $10,000 to $7,500.
But let's assume he still wants to maintain exposure to BNB. AKA he plans to HODL.
So, he buys back 10 BNB at $250 and now his cost basis is $2500.
On the surface, you might wonder why everybody doesn’t use this strategy when their portfolio is down?!
Well, the upside is that you can reduce your tax liability NOW. But you're just pushing it out into the future.
Which can have benefits, but it's important to also understand the downsides and risks to Tax Loss Harvesting.
Potential Risks To Crypto Tax Loss Harvesting
One risk is that the token you are tax loss harvesting gets classified as an equity.
In US equity markets you cannot simply sell an equity like Tesla stock, and buy it back.
This violates the "Wash Sale Rule" and the IRS will not allow you to claim the loss on your tax return.
But the Wash Sale Rule is a bit vague, and many "robo advisors" use a strategy of Tax Loss Harvesting by buying & selling similar ETFs and Index funds.
For example, the robo advisor I used before quitting "stonks" would sell shares of Vanguard S&P 500 Index funds, and buy back a similar equity like the Spyder S&P 500 ETF to maintain exposure to the S&P 500.
How Tax Loss Harvesting Could Increase Your Taxes
But if we return to the CZ example: if the SEC classified BNB as an equity, he might be retroactively penalized for claiming a tax loss on his BNB
Another potential downside is that by selling his BNB he has both:
1)Lowered his cost basis from 5000👉2500 which means he will pay more tax when he does sell.
2)Reset the capital gains clock, and will have to wait another 12-months to qualify for long term capital gains tax discount.
That’s potentially bad If BNB goes to $750 6-months from now and he sells.
This means his cost basis is $2500 and he sells for a $7500. This is $5000 in profit. This $5000 profit taxed at short term capital gains rates (up to 2x higher).
And you might be wondering,"If he pays tax on $5k gains next year, but he offset $2500 in gains this year isn't that only $2500 in gains? Isn't that the same as if he held with a $5000 cost basis and sold at $7500 which is $2500 in gains, too?"
Assume CZ is single, living in the US, in the highest tax bracket.
He will qualify for the Long Term capital gains tax rate of 20% in the scenario where he does not Tax Loss Harvest. Long Term capital gains tax on $2500 means he pays $500 in taxes.
But lets look at the the tax loss harvesting scenario.
We will assume he offsets $2500 of Long Term gains this year. This is $500 in tax savings. But now when he sells for a $5000 gain next year, he pays the 35% short term capital gains tax rate.
The tax bill in this sceanario is $1750.
$1750 - $500 = $1250 in net taxable gains So he pays 2.5x more in tax by Tax Loss Harvesting vs. just HODLing.
When To Consider Crypto Tax Loss Harvesting
This is why tax loss harvesting is not a strategy for everybody. It should be carefully considered with a competent advisor. So now you might be wondering "when should I tax loss harvest?" It may be worth considering if:
- You plan to HODL the position long term vs. take profits in the next 12-months.
- You have high realized gains but don't have enough cash to pay the tax bill.
- You don’t want to have to sell your stack while it’s down in order to pay the tax man.
- You have other investing gains that you want to offset (like selling a house, business, or other investments).
This last point is one that I personally used. I sold one of my businesses this year.
I don't sell a business every year, so I decided to tax loss harvest some of my crypto losses while the market was down to offset the impending tax bill.
Final Toughts On Crypto Tax Loss Harvesting
Which brings up an important final point:
Tax loss harvesting requires both strategic planning and an accurate cost basis for your tokens to determine its impact.
You cannot wait until April 15th (in the US) to tax loss harvest.
It is important to both have an accurate picture of your taxable gains and cost bases BEFORE January 1st.
This allows you to make strategic decisions with your tax planner when the window is still open for action.
Not sure how to get an accurate cost basis for your tokens? Or how to determine what your gains/losses are for the year?
Then you might need to check out our Crypto Tax Made Easy course, or Done-For-You crypto tax service before the tax year ends!
*ALWAYS consult an tax professional before implementing an advanced strategy like tax loss harvesting. This article is not meant to be tax advice, rather to give you something to discuss with a qualified tax professional.*