Can You Tax Loss Harvest Crypto? Here’s How

Tax loss harvesting is an investment strategy that allows individuals to reduce their tax liability by selling investments at a loss. This process involves intentionally selling assets that have decreased in value to realize a capital loss. These realized losses can then be used to offset taxable capital gains from other investments, potentially leading to a lower overall tax bill. The strategy focuses on optimizing an investor’s tax position without necessarily altering their long-term investment goals.

How Tax Loss Harvesting Works

Capital assets, which include investments such as stocks, bonds, and cryptocurrencies, are treated for tax purposes based on whether they generate a gain or a loss upon sale. The Internal Revenue Service (IRS) classifies gains and losses as either short-term or long-term, depending on the asset’s holding period. Short-term gains and losses apply to assets held for one year or less, while long-term gains and losses are for assets held for more than one year.

When an investor sells a capital asset for less than its cost basis, a capital loss is realized. These realized capital losses can first be used to offset any capital gains. Short-term losses are used to offset short-term gains, and long-term losses offset long-term gains. If there are remaining losses after offsetting gains of the same type, they can then be used to offset gains of the other type.

Should an investor’s total capital losses exceed their total capital gains, a portion of these excess losses can be used to reduce ordinary income. The maximum amount of net capital loss that can be deducted against ordinary income is $3,000 per year, or $1,500 if married filing separately. Any remaining capital losses beyond this annual limit can be carried forward indefinitely to offset capital gains or a limited amount of ordinary income in future tax years.

The IRS views digital assets, including cryptocurrencies, as property for federal tax purposes. This means general tax principles for property transactions, including capital gains and losses, apply to cryptocurrency. Therefore, selling crypto at a loss generates a capital loss that can be used like losses from other capital assets, making tax loss harvesting viable for crypto investors.

The Wash Sale Rule and Crypto

The wash sale rule is a specific tax regulation designed to prevent investors from claiming an artificial loss. This rule applies to stocks and securities, prohibiting the deduction of a loss if an investor sells a security and then purchases a “substantially identical” security within a 30-day period before or after the sale date. The purpose of this rule is to ensure that investors truly incur an economic loss before claiming a tax benefit. If a wash sale occurs, the disallowed loss is added to the cost basis of the newly acquired security, deferring the tax benefit.

Under current U.S. tax law, the wash sale rule does not apply to cryptocurrencies. This is because the IRS classifies virtual currencies as property, not securities. This distinction means an investor can sell a cryptocurrency at a loss and immediately repurchase the same crypto without triggering the wash sale rule. This provides a significant advantage for crypto investors, allowing them to realize a capital loss while maintaining their desired crypto holdings and market exposure. For example, an investor could sell Bitcoin at a loss and buy it back moments later, harvesting the loss without interrupting their investment.

While the wash sale rule currently does not apply to cryptocurrencies, discussions and proposals exist to extend its application to digital assets. Lawmakers have suggested this could change to align crypto tax treatment with traditional securities. Any legislative changes would likely apply prospectively, meaning the current ability to perform wash sales with crypto remains intact until new laws are enacted.

Calculating and Reporting Crypto Capital Losses

Accurately calculating the cost basis of cryptocurrency assets is a fundamental step in determining capital losses. The cost basis generally includes the original purchase price plus any acquisition fees. When multiple units of the same cryptocurrency are acquired at different prices, various accounting methods can be used to determine which specific units are being sold.

One common method is Specific Identification (Spec ID), which allows investors to choose the exact units being sold, optimizing for tax outcomes by selecting units with a higher cost basis. Another method is First-In, First-Out (FIFO), which assumes the first units acquired are the first sold. Highest-In, First-Out (HIFO) assumes the highest cost units are sold first. Maintaining detailed records of all crypto transactions, including purchase and sale dates, prices, and fees, is essential for accurate cost basis calculations.

Once capital losses are calculated, they must be reported to the IRS using specific tax forms. Form 8949 is used to list each individual cryptocurrency transaction. For each transaction, investors must provide the asset description, acquisition and sale dates, sale proceeds, cost basis, and the calculated gain or loss. Transactions are categorized on Form 8949 as either short-term or long-term.

After completing Form 8949, the totals from short-term and long-term capital gains and losses are transferred to Schedule D. Schedule D provides an overall summary of all capital gains and losses, including cryptocurrency, for the tax year. This form then computes the net capital gain or loss, which is reported on the taxpayer’s Form 1040. Thorough record-keeping is essential to ensure compliance with IRS guidelines.