Virtual Currency Trading: The wash sale tax tip that every crypto trader should know

As virtual currency trading and ownership continues to grow, the U.S. regulatory policies and guidance remain vague, confusing, and inconsistent. However, based on current law, tax planning methods exist to help you lower your crypto tax bill. In the current regulatory environment, a tax loophole, or a tax planning strategy to legally reduce your tax liability, exists for crypto traders. The tax strategy focuses on the applicability of the Wash Sale rule as it relates to trading cryptocurrencies. It is important to note that the regulatory environment surrounding virtual currency is rapidly evolving, and so, crypto traders should remain up to date on newly released crypto guidance and policy.

Below, I will detail the wash sale rule as it relates to trading crypto as well as explain the tax strategy for lowering your cypto tax bill. Every crypto trader should know the wash sale tax tip.

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What is a wash sale?

The wash sale rule exists to prevent taxpayers from creating artificial tax losses from the sale of stock and securities. The IRS established the tax guidance to prevent a tax deduction for a security sold in a wash sale. The guidance defines a wash sale as a sale that occurs when a taxpayer sells or trades a security (includes stocks and other items defined as securities) at a loss, and within 30 days before or after the sale (creating a 61-day window), buys the same or substantially identical security. As a result, the wash sale rule prevents the taxpayer from recognizing and deducting a capital loss on the sale of the security. It is important to note that the wash sale rule does not apply to capital gains.

How does the wash sale rule apply to cryptocurrency?

Section 1091 of the IRC governs the wash sale rule. The code section specifically applies to stock and securities; therefore, the wash sale rule does not apply to other types of assets, such as property. Currently, cryptocurrencies are treated as property. The Securities and Exchange Commission (SEC) utilized the Howey Test to determine whether or not cryptocurrencies should be treated as a security. Overall, SEC determined that virtual currencies, including Bitcoin and Ethereum, are not securities. However, the SEC does consider initial coin offerings and other cryptos as securities. It is important to confirm the cryptocurrency asset classification before participating in crypto trading.

So, to answer the question, experts believe that the wash sale rule does not apply to cryptocurrency. IRS guidance does not explicitly confirm the validity of this crypto trading tax tip, but experts believe the current crypto tax guidance allows for the cryptocurrency wash sale exception.

What is the crypto trading tax tip?

Because cryptocurrencies are treated as property, crypto trading has a major tax advantage over traditional security trading. It is important to note that this crypto tax advantage only applies to casual traders. Full-time traders face different rules and should ignore this post.

The best way to describe the tax strategy is via an example. So, on December 1, you buy 1 BTC for $10,000. On December 15, the 1 BTC is now trading at $8,000. You sell the BTC at this price, generating a $2,000 capital loss. Additionally, you buy back 1 BTC shortly after, reestablishing your cryptocurrency position.

If the IRS considers cryptocurrency a security, the wash sale rule applies to the example; therefore, you cannot recognize or net the capital loss on your tax return. However, because the IRS classifies the virtual currency as property, the wash sale rules does not apply to the example; therefore, you can recognize the capital loss on your tax return. It is important to note that capital losses can offset capital gains. So, you can offset capital gains generated from cryptocurrencies, stocks, or other capital assets. Additionally, if you have a net capital loss position (realized capital losses exceed realized capital gains), you may deduct up to $3,000 capital loss on your tax return.

This is a great crypto tax strategy to implement throughout the year, using it at times when your cryptocurrency position decreases in value. However, like any tax strategy, there is risk involved. As I mentioned above, the regulatory nature of cryptocurrency is evolving and expanding. At any moment, the IRS can change the rule, causing the wash sale rule to apply to cryptocurrency under Section 1091. It is conservative to assume the IRS will eventually release guidance to disallow wash sales of virtual currency. Until then, you can take advantage of the cryptocurrency wash sale exception tax strategy.

Please share with others to help them learn about the wash sale tax tip every cryptocurrency trader should know about. As always, please comment below or connect with via my contact page if you have any questions relating to the virtual currency trading tax tip.

Disclaimer: As stated in my disclaimer page, this post and all posts on Textbook Tax are informational only and are not intended as tax advice. For tax advice, please consult a tax professional.