Crypto investors may be able to get a lower tax bill if they utilize this tax loophole

In spite of the massive losses in the cryptocurrency market in 2022, some investors could have saved big by attempting to harvest tax losses, a strategy useful for individuals with declining assets. Planning ahead for 2023 isn't a bad idea since it's too late to take advantage of the 2022 tax year.

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Identifying crypto gains and losses is the first step in understanding tax-loss harvesting.

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Virtual currency is considered property by the IRS. In the case of losses on investments, the IRS allows you to use those losses to offset capital gains on investments made after the loss. The remaining capital losses can be offset by up to $3,000 from regular income at tax time if capital losses exceed annual capital gains.

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Ordinary income, such as what you earn at work or through side jobs, is taxed at a higher rate than capital gains.

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If you have capital gains, you can offset them only with losses of the same type. A short-term gain, which means you sold your crypto before one year, can only be reduced by a short-term loss, whereas a long-term gain, which means you held your crypto longer than a year, can only be reduced by a long-term loss.

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Using these rules to your advantage is called tax-loss harvesting, and crypto holders can use it to their advantage, unlike other investors.

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Cryptocurrency's uniqueness

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It's not currently possible to wash-sell crypto, unlike stocks. Generally, the IRS claims you cannot deduct a loss on the sale of a security and its replacement with a similar security or one that is "substantially identical".

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In theory, you could sell your crypto, claim the loss, and buy it back right away.

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CoinTracker.io's CEO Shehan Chandrasekera cautions against abusing this loophole to abuse the tax system.

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A tax benefit would be disallowed by the IRS if you constantly sell crypto at a loss and immediately buy the same coin, Chandrasekera tells Trade Algo.

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"I wouldn't recommend anyone do that. Wait a reasonable period of time," he suggests. 

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Chandrasekera says some traders perform this every quarter, every month or every other week.

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Capital gains can be reduced or eliminated by harvesting tax losses

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Knowing how harvesting crypto losses will affect your tax bill is important before moving forward.

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Capital gains tax applies to profits earned from selling crypto that has increased in value over a year. The best way to reduce or eliminate your tax liability is to offset capital gains with capital losses, which are taxed at lower rates than ordinary income.

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Consider the example of purchasing crypto for $10,000 and selling it for $13,000 later on. Your capital gains would be taxable at $3,000 each. Chandrasekera says that you would be able to offset your taxes if you suffered losses of $3,000 on crypto transactions.

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Chandrasekera says that you can carry over the remaining $7,000 for use in offsetting future gains if you incur $10,000 in losses in one year, but only $3,000 in gains.

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“The funds can be carried over indefinitely,” he explained. I don't mind if you don't have any gains in the second year. It can be carried forward until the day you die."

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In order to harvest crypto tax losses, you need to carefully track what you paid and sold your crypto for. Some investors may have difficulty tracking their transactions without the use of reputable software that can do so.

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Investors' tax situations are unique. Before making any changes to your portfolio, speak with your tax advisor.