Learn: What is the wash-sale rule in Crypto?
Understanding the Wash Sale Rule and Its Application in the Crypto Market
The Internal Revenue Service (IRS) in the United States established the wash-sale rule, which restricts investors from deducting a tax loss from their taxes if they sell an investment at a loss and subsequently buy a virtually identical security within the 30-day window. Instead, they must factor the loss into the new security’s cost base, which will reduce their gain or raise their loss when they ultimately sell the new asset.
Cost basis refers to the original value of an asset, such as a stock or a cryptocurrency, that is used to determine the taxable gain or loss when the asset is sold or disposed of. The cost basis is typically the purchase price of the asset, including any fees or commissions associated with the purchase. The cost basis may be changed to reflect the asset’s fair market value at the time of acquisition if the asset was received as a gift or through inheritance.
When an asset is sold, the capital gain or loss is determined using the cost basis. The investor obtains a capital gain and may be subject to taxation on that gain if the asset’s sale price exceeds its cost basis. The investor experiences a capital loss if the sale price is less than the cost basis. This loss can be used to offset capital gains and minimize the investor’s tax burden.
“Substantially identical” refers to securities that are almost identical to the security sold, as in the case of purchasing a stock, selling it, and purchasing the original stock back within 30 days. However, it can be difficult to determine what constitutes a substantially identical security, and the IRS has broad discretion in making this determination.
The wash-sale rule was created to stop investors from claiming tax deductions for losses while maintaining their portfolio’s original structure. All forms of securities, such as stocks, bonds, mutual funds and options, are covered by this rule.
For instance, the wash-sale rule would likely apply, and the investor would not be able to claim the tax loss on the sale if the investor sold shares of a certain company at a loss and then purchased shares of the same company or a company that is similar in the same industrial sector within 30 days. In a similar vein, if an investor sells shares in a mutual fund that tracks the S&P 500 index and then purchases shares of a different mutual fund that tracks the same index within 30 days, the investor is subject to a 30-day penalty.
Since the IRS has not offered clear guidance on this subject, it is unclear how the wash-sale regulation applies to cryptocurrencies. The wash-sale rule is usually believed to apply to cryptocurrencies in the same manner as it does to other kinds of assets, though.
The U.S. government tried to implement a crypto wash-sale rule through the Build Better Act in 2021, which passed in the House of Representatives but was ultimately defeated in the Senate. That said, if an investor sells a cryptocurrency at a loss and buys it in a 30-day window, the IRS considers the new purchase to be a “wash sale,” which means that the loss is disallowed and added to the cost basis of the new security.
Cryptocurrency investors may employ tax-loss harvesting opportunities and tax planning strategies to reduce their tax liability, but they must be cautious to avoid breaking the wash-sale rule.
To ensure compliance with the rule and other crypto tax requirements, it is crucial to maintain precise records of all cryptocurrency transactions. Investors in cryptocurrencies can benefit from consulting with a tax expert to better understand the complicated world of crypto taxes and make sure they are maximizing tax benefits while reducing tax obligations.
Understanding the wash-sale rule and other tax regulations is crucial for crypto investors to minimize their tax liabilities and stay compliant with IRS rules. Here’s a step-by-step explanation of how the wash-sale rule works:
- An investor sells a security, such as a stock or a cryptocurrency, at a loss.
- Within 30 days before or after the sale, the investor buys the same or a substantially identical security.
- The wash-sale rule applies, and the loss is disallowed for tax purposes.
- The cost basis of the new security is adjusted to reflect the disallowed loss.
- If the investor later sells the new security for a gain, the adjusted cost basis is used to calculate the taxable gain.
Consider a scenario where an investor purchases 1 Bitcoin (BTC) for $50,000 and then sells it for $40,000, suffering a loss of $10,000. The wash-sale rule will be applied if the investor purchases another BTC within 30 days of the transaction for $55,000; in this case, the $10,000 loss is disallowed, and the new Bitcoin’s cost basis is changed to $50,000 to reflect this loss.
If the investor later sold the new BTC for $70,000, the taxable gain would be $20,000 ($70,000–$50,000) as opposed to $15,000, as it would have been if the cost basis had not been changed.
The wash-sale regulation barred the investor from using the $10,000 loss they sustained on the initial Bitcoin purchase, despite the fact that they had incurred a loss. The disallowed loss was instead applied to the new Bitcoin’s cost basis, raising the taxable gain from the sale of the new Bitcoin.