On September 13th, the Committee of Ways and Means published a summary report of ways through which the U.S government is planning to fund the infrastructure bill. One of them includes closing the loophole in wash sales rule – which has allowed crypto investors & traders to utilize a “tax-loss harvesting strategy” for reducing their tax bill!
What is a wash sale?
According to Investopedia, a ‘wash sale’ occurs when an individual sells a stock or security at a loss, only to purchase a substantially identical stock or security within 30 days before or after the sale.
This means traders can claim the loss to reduce their tax bill, as well as buy back the stock or security at a lesser price than before!
What is the wash sale rule?
The IRS clearly sees ‘wash sales’ as an attempt towards manipulating tax laws to reduce tax. This is why the IRS introduced a wash sales rule under Section 1091 of the IRS code.
The Wash-Sale rule doesn’t allow an individual to claim loss incurred from a wash sale for tax purposes. Let’s understand with an example:
Joshua purchases 50 shares of a company stock for $6,000 on May 1st, 2020. The shares of the company are trading at a lower price on May 2nd, 2021. So, he sells his 50 shares for $4,000. Within two weeks, he buys back the same 50 shares for $3000.
He incurred an initial long-term capital loss of $2,000. But he can’t claim it because of the wash-sale rule. If he had bought it back after 31 days, he would have been able to claim the loss.
Does the wash sale rule apply to crypto?
Currently, the wash sale rule is subjected to “stocks & securities” only. According to IRS Notice 2014-21, crypto assets are treated as “property”. Because of which the wash-sale rule doesn’t apply to crypto assets right now.
Crypto wash sales EXAMPLE:
For example, assume Joshua purchases bitcoin worth $10,000 on January 1st 2021. He sells the same bitcoin for $4,000 on Sept 7th 2021, making a loss. After 7 days, he buys it back at $5,000. He will claim a loss of $6,000, thus reducing his crypto tax. This is tax-loss harvesting.
And many crypto-investors use it to reduce their crypto tax bill. However, the Internal Revenue Service and Biden Administration are working together to better define regulation and close all loopholes in the crypto space – for generating additional tax revenue required to fund the massive infrastructure bill.
The Committee of Ways and Means is reviewing the infrastructure bill. It is a chief tax-writing committee of the United States House of Representatives that has jurisdiction over all taxation, tariffs, and other revenue-raising measures, as well as a number of other programs.
Sec. 138153 of a summary report published by the committee, plans to subject “digital assets” to the wash sale rule:
This section (Sec. 138153) includes commodities, currencies, and digital assets in the wash sale rule, an anti-abuse rule previously applicable to stock and other securities. The wash sale rule in section 1091 prevents taxpayers from claiming tax losses while retaining an interest in the loss asset.
Implications of wash sale rule on crypto assets
Consider our crypto wash sales example – Joshua’s BTC transaction. Joshua won’t be able to claim that loss of $8,000 if crypto assets are also subjected to the wash sale rule. However, this doesn’t mean that there’s absolutely no benefit of wash sale losses for crypto taxpayers.
Loss incurred during a wash sale can be added to the cost basis of the crypto asset purchased within 30 days of the sale. This means that Joshua can add his wash sale loss of $6,000 to the cost basis of his newly purchased BTC of $5,000. ( Total cost basis = $11,000).
Assuming after 3 months, BTC price increases and Joshua sells his BTC for $15,000. He will be liable to pay a capital gain of $4,000 ($15,000 – 11,000).
If Joshua doesn’t add his wash sale loss to the cost basis of his newly purchased BTC, he will incorrectly report and pay tax on a higher capital gain of $10,000!!
As part of the infrastructure bill, all centralized exchanges in the crypto space will adopt 1099 information reporting. This means cryptocurrency brokers/exchanges will use Form 1099-B for reporting their customers’ gains and losses during a tax year, to the IRS & the customer as well.
For those who trade on a single exchange and receive a Form 1099-B, capital gains reported in the form is accurate. But for those who traded on multiple exchanges, and received Form 1099-B from all the exchanges might end up paying higher taxes than the actual amount owed. Because whenever a crypto asset is transferred into or out of a cryptocurrency broker/exchange, the broker won’t have the right cost basis of the crypto asset.
And since exchanges send the form to the IRS as well, it will be your job to aggregate transaction data from all of your crypto platforms, track and prove the right cost basis of your sales. AND remember to add the wash sale loss amount to the cost basis. You could do it manually. Alternatively, you can simplify the process using a crypto tax software like bear.tax.
If the Ways and Means’ suggestions are adopted, the wash sales rule of the IRS code will be applicable to “digital assets” after December 31, 2021.
This means investors still have more than 3 months to utilize tax-loss harvesting strategy to reduce their taxes for FY 2021-22 without the wash sale restriction.