Rules and regulations pertaining to cryptocurrency transactions are limited. The only guidance we have is the IRS notice 2014-21. This notice provided that certain cryptocurrencies, labelled “convertible virtual currencies” are treated as “property” for U.S. federal income tax purposes, and thus, “general tax principles applicable to property transactions” would apply to transactions involving convertible virtual currencies. The Internal Revenue Service (IRS) defined “convertible virtual currencies” as those virtual or cryptocurrencies that had “an equivalent value in real currency, or that acts as a substitute for real currency.” By going with the property definition, gains and losses arising from cryptocurrency transactions are capital in nature, not ordinary income.
Most importantly, it should be highlighted that capital losses arising from “property” transactions are not subject to wash sales rules; wash sales rules are applicable to only “stocks or securities” per I.R.C § 1091.
I.R.C § 1091.
(a) In the case of any loss claimed to have been sustained from any sale or other disposition of shares of stock or securities where it appears that, within a period beginning 30 days before the date of such sale or disposition and ending 30 days after such date, the taxpayer has acquired (by purchase or by an exchange on which the entire amount of gain or loss was recognized by law), or has entered into a contract or option so to acquire, substantially identical stock or securities, then no deduction shall be allowed under §165 unless the taxpayer is a dealer in stock or securities and the loss is sustained in a transaction made in the ordinary course of such business. For purposes of this section, the term “stock or securities” shall, except as provided in regulations, include contracts or options to acquire or sell stock or securities”.
In simple terms, a wash sale is a sale of a stock or security at a loss and repurchase of the same or substantially identical security 30 days before or after. Wash sale regulations protect against an investor who holds an unrealized loss and wishes to make it claimable as a tax deduction within the current tax year.
Losses arising from cryptocurrency sales are immune to wash sales rules and creates a great tax planning opportunity for certain taxpayers. Let’s look at the following example. Imagine you purchased 1 BTC for $5,000 on November 15th, 2018. On December 10th, price of 1 BTC went down to $3,000. If you were to sell this 1 BTC on December 10th, you would incur a $2,000 ($5,000 – $3,000) short-term capital loss. Since cryptocurrencies like bitcoin are treated as property by the IRS, this loss which would typically be disallowed under wash sales rules, is allowed. In other words, if you had the same transaction with stocks, the IRS would disallow $2,000 of short-term loss because you purchased the stock within 30 days prior to the disposition. The idea behind the wash sale rule is to prevent taxpayers from claiming artificial losses. Since this rule is not applicable to cryptocurrencies, in the example above, the taxpayer can claim a deductible loss and can renter the position at $2,000 per BTC again.
In summary, Capital loss harvesting is a handy year-end tax planning tool. Note that this strategy does not fit every taxpayer. Please consult your tax advisor to see if this strategy is a good addition to your tax plan.