This Strategy May Help You Navigate ‘Wash-sale’ Rule
By Sean Wandrei
It is that time of year when taxpayers are looking for ways to reduce their tax liability. It has been a volatile year for the stock and cryptocurrency markets. There may have been some capital gains generated in the beginning of the year when stocks were sold and the markets were doing better than they are now. Now, as the year has progressed, there may be stocks that you are holding that have declined in value. These stocks are ripe for tax-loss harvesting.
Tax-loss harvesting is a strategy used to recognize capital losses by selling capital assets that have declined in value to offset capital gain already recognized. If you have capital gains from stocks that you have sold during the year, you can offset those gains by selling other stocks that have declined in value to generate a capital loss. The capital losses would offset the capital gains that would reduce the amount of taxes that would be paid on those gains by eliminating them. If you end up with capital losses in excess of capital gains during the year, you can deduct up to $3,000 of the net capital loss in the current year. Any capital loss in excess of $3,000 would be carried forward and used to offset future capital gains.
“Tax-loss harvesting is a strategy used to recognize capital losses by selling capital assets that have declined in value to offset capital gain already recognized.”
There could be an issue with this strategy, as the ‘wash-sale rule’ could limit its effectiveness. The wash-sale rule states that, if you are deducting a loss, you cannot buy a ‘substantially identical’ stock or security for 30 days up to the date of sale and 30 days after. If you do, the capital loss may be disallowed. This could be an issue when you sell a stock that you want to stay in, just to generate a capital loss.
‘Substantially identical’ generally means you cannot sell Tesla stock and reacquire Tesla right before or after the sale. If you are selling your Tesla stock just to generate losses and still want to be in Tesla stock, you need to wait 30 days to reacquire it.
What if you are investing in cryptocurrencies? The two most popular cryptocurrencies are Bitcoin and Ethereum, but there are hundreds more that you could invest in. Cryptocurrency prices can be volatile and widely fluctuate throughout the year. Bitcoin has dropped from a price of $66,000 per coin to $16,000 over the past year. Ethereum has seen similar declines over the year.
There may have been many investors who got into the cryptocurrency game hoping to ride the wave of optimism and are now looking at their portfolio, which shows built-in capital losses on their cryptocurrency investments. In 2014, the IRS declared cryptocurrencies to be a capital asset. As of this writing, cryptocurrencies are not stocks or securities and do not fall under the wash-sale rules. There has been some discussion in Washington, D.C. to expand the wash-sale rules to include cryptocurrencies, but as of now, that has not materialized.
If you believe in the underlying blockchain technology and the cryptocurrency associated with it, you may be a long-term investor and want to hold onto the investment believing that there will be future gains. There is an opportunity to reduce your tax liability by selling cryptocurrency that has decreased in value for a capital loss and then buy the same cryptocurrency immediately after the sale. This would not violate the wash-sale rules since cryptocurrency is not viewed as a stock or security. The capital losses generated by this strategy could be used to offset any capital gains that you may have.
Are there some risks with tax-loss harvesting? Of course there are. There is usually a transaction fee associated with buying and selling cryptocurrencies that some exchanges (such as Coinbase, Kraken, or others) charge. This fee could be as high as 4%. Does the cost of the transaction outweigh the tax savings that could be generated from this strategy? As mentioned previously, there are talks of pulling cryptocurrencies into the wash-sale rule, so this should be monitored if you are thinking about this strategy.
Lastly, while tax-loss harvesting defers your capital gains, it does not eliminate them forever. This is a strategy based on the time value of money where tax savings now can be used to invest in more capital assets that will generate income in the future.
As with any tax article, the famous last words: as always, you should see your tax professional advisor if you have any tax questions or concerns.
Sean Wandrei is a senior lecturer in Taxation at the Isenberg School of Management at UMass Amherst; [email protected]