There are various loopholes investors can consider when filing taxes. People have used these loopholes to avoid paying heavy taxes on capital gains on their investments while benefiting from tax deductions on losses they had through trading. One tax loophole is a wash sale, against which the IRS even implemented its own rule. How do these loopholes and rules apply to cryptocurrency?
Including cryptocurrency transactions in tax filings is still a grey area to the average investor and even some tax professionals. However, as crypto has become more widely adopted, the IRS has required that certain transactions involving digital currency be reported on a tax return.
What are wash-sale rules?
Wash-sale rules apply when trades attempt to sell a security so that they can gain tax-deductible losses. If a security is sold at a loss, and the trader then purchases a “substantially identical” security within 30 days from when they sold the initial investment, they cannot claim the initial loss as a tax deduction.
The rule also restricts an investor from claiming a loss as a tax deduction if they sell a security within 30 days and then a company they own or their spouse buys a “substantially identical” security in that period. The wash-sale rule was created by the IRS in the 1920s, as the federal agency implemented this restriction so that traders can’t create loopholes when filing tax returns.
An example of the wash-sale rule applying to transactions would be if someone were to buy 10 shares at $100 each, and within 30 days, the price drops to $50. If that person sells their shares within the 30-day period and suffers a $500 loss and repurchases the same stock or a “substantially identical” security, the IRS will not allow that trader to claim the $500 loss as a tax deduction.
What has frustrated investors for decades is what necessarily classifies as a “substantially identical” security. As the agency’s definition of what constitutes as “substantially identical” securities can be vague, it's best to consult a tax professional on the matter. Basically, if you’re trying to avoid wash-sale rules from applying to you, don't buy securities similar to one that resulted in a loss for you within 20 days (for example, buying Rivian after losing on Tesla).
Do wash-sale rules apply to crypto?
For 2021, wash-sale rules don't apply to cryptocurrencies, allowing you to claim tax-deductible losses on them and reinvest in tokens within 30 days. However, starting in 2022, Biden’s infrastructure bill will include cryptocurrencies in the wash-sale rules.
How to work around wash-sale rules
If you want to claim tax-deductible losses and reinvest in crypto that has cost you, simply wait more than 30 days. For example, if you purchased Bitcoin, suffered a loss from that investment, and sold your holdings in it, wait for 31 days before repurchasing the token.