The month of May was a rough month for almost every virtual currency. In many cases crypto currencies lost roughly half their value in less than three weeks. For example, bitcoin had a price of $59,000 on May 3, 2021, but plunged to as low as $30,000 by the middle of May. Similarly, ether reached its all-time high of roughly $4,200 on May 11, 2021, but plummeted to $1,700 by the middle of May. Bitcoin and ether were not alone in the dramatic price correction that occurred in May as almost all crypto currencies were subject to the nose dive. The price dip across crypto presents an individual who bought in at the top of the market the opportunity to harvest a tax loss. The remainder of this article explains the rules for harvesting a tax loss and why it may be beneficial.
Internal Revenue Code section 1211 allows an individual to take losses to completely offset his/her capital gains plus an additional $3,000 of loss is allowed if the individual’s capital losses exceed his/her capital gains by such an amount. When calculating the amount of capital losses an individual should categorize the loss as either short-term or long-term. A loss is considered short-term if the property is held for one year or less. Conversely, a loss is considered long-term if the property is held for more than one year.
Short-term capital gains and losses are reported in part I of the Form 8949. Long-term capital gains and losses are reported in part II of the Form 8949. Short-term capital losses are first deducted against short-term capital gains. Similarly, long-term capital losses are first deducted against long-term capital gains. If there are unused capital losses, either short-term or long-term, after deducting against the gains of that particular category, the net capital losses can be used to deducted against the other category of capital gains. For example, if there are unused short-term capital losses after offsetting all the short-term capital gains, an individual can use the excess short-term capital losses to offset any long-term capital gains that exist after reducing the long-term capital gains by the long-term capital losses.
If an individual has a total net capital loss (meaning his/her short-term capital losses plus long-term capital losses exceed his/her short-term capital gains plus long-term capital gains), the individual can only take a deduction of $3,000 in the current tax year. If the taxpayer has more than $3,000 of total net capital loss, the individual is able to carryover the excess loss to use in future tax years. When an individual has excess short-term capital losses and long-term capital losses, the individual must use his/her short-term capital losses first when determining what counts towards the $3,000 annual threshold. This is true regardless of the dates the transactions that bring about the short-term or long-term capital losses occur. Therefore, long-term capital losses are more likely to be preserved for the capital loss carryover. While these rules are nuanced and extremely detailed, most individuals won’t have to apply all these rules to harvest a tax loss!
Let’s examine an example that may be more common for an individual who holds a crypto position. McGee found bitcoin in 2018 and purchased one bitcoin for $4,000. McGee holds his bitcoin but becomes even more bullish in April 2021. As a result of his bullish feeling, McGee decides to purchase another bitcoin for $60,000. McGee keeps meticulous records for each transaction including the date, time, amount of crypto acquired, and the amount of USD used for each transaction. Therefore, McGee is able to identify a specific unit of his crypto positions and dispose of it in any order he wishes. This is critical because if he was not able to satisfy the four requirements to be able to identify a specific unit of crypto, he would be stuck with the FIFO method of accounting.
In June 2021, the price of bitcoin is at $40,000 and McGee decides to sell some of his bitcoin to harvest a tax loss. It is important to point out that it is absolutely vital that McGee is able to satisfy the four requirements to be able to identify a specific unit of bitcoin as all of McGee’s bitcoin purchased in 2018 has significantly appreciated while the bitcoin purchased in April 2021 is underwater. McGee sells 15 percent of his bitcoin he purchased at $60,000 (15,000,000 satoshis) while the price is at $40,000. As a result, McGee receives $6,000 in cash. McGee’s basis in his one bitcoin purchased at $60,000 is evenly distributed among all of his satoshis. As a result, when he decides to sell 15 percent of that purchase, 15,000,000 satoshis, his basis in the amount of bitcoin he sold is $9,000 ($60,000 * 0.15). To determine if there is a short-term capital gain or loss on the transaction an individual would take the fair market value of the sale, in this case $6,000 ($40,000 * 0.15) and subtract the individual’s basis in the position being sold, in this case $9,000 ($60,000 * 0.15). As a result, a short-term capital loss is created in the amount of $3,000 ($6,000 – $9,000).
Assuming McGee has no other capital transactions in 2021, he will be able to take a $3,000 capital loss deduction. To see why this is tax efficient, assume McGee has a 35 percent effective tax rate. Using the $3,000 deduction, McGee would be able to reduce his taxes by $1,050 ($3,000 * 0.35 McGee’s effective tax rate for 2021) for the 2021 tax year. Combining the $1,050 with the $6,000 McGee received from selling his 0.15 bitcoin to harvest the loss, McGee would have an extra $7,050 in capital to reinvest in assets.
While nobody likes seeing their assets go down, individuals who purchased crypto at the top of the market will be able to harvest a tax loss as a result of the recent market correction. By creating a tax loss, an individual will be able to increase his/her working capital by an amount of the product of his/her effective tax rate and $3,000 (assuming the individual fully harvests the loss). Our next article will explore the interesting questions surrounding how an individual can redeploy the harvested losses back into the crypto ecosystem. If you have any questions regarding the topics covered in this publication, please contact us.
