In our previous publication we discussed how the recent crypto market correction presented an opportunity for an individual who bought in at the top of the market to harvest a tax loss. The question this publication examines is when an individual can redeploy the amount harvested in a tax loss transaction back into various assets. For example, could an individual harvest a tax loss from bitcoin and immediately redeploy the harvested tax loss back into bitcoin instantaneously? What if instead, the individual waited a minute, an hour, a day, a week, or a month? What if instead of redeploying the harvested tax loss in bitcoin, the individual redeploys the money into ether (or another virtual currency instantaneously) or puts the money into a company holding a large amount of bitcoin such as MicroStrategy. This publication explores two parts of the law, the wash sale rule and the economic substance doctrine, that could lend an individual assistance when attempting to answer these questions.
The Wash Sale Rule
The wash sale rule was put in place to disallow an individual from harvesting a tax loss on the sale of stock within a 61 day window (30 days before and after the sale of the stock). If an individual sells a stock at a loss and then purchases the same stock or a substantially identical stock within the 61 day window, the loss is disallowed by the wash sale rule discussed at IRC section 1091 and the accompanying regulations. While this rule is detailed and well understood, the wash sale rule clearly does not apply to crypto currency. The IRS has been clear that crypto is property and not stock. Therefore, IRC section 1091 does not apply to crypto.
The Economic Substance Doctrine
The economic substance doctrine is a common law rule that unwinds actions taken by a taxpayer despite the taxpayer meeting all of the requirements of the IRC if the taxpayer cannot show the transaction has economic substance or a business purpose. The common law doctrine was codified in 2010 with the addition of IRC section 7701(o). However, the Code provision makes clear that the determination of whether the economic substance doctrine is relevant to a transaction shall be determined based on the judicial history of the common law rule and as if IRC section 7701(o) was never enacted.
There are two prongs to an economic substance doctrine analysis. The first prong inquires as to whether the transaction being entered into changes in a meaningful way the taxpayer’s economic position (commonly referred to as the objective prong of the doctrine). The second prong inquires whether the taxpayer had a subjective non-tax purpose for entering into the transaction (commonly referred to as the subjective prong of the doctrine). At its core, the doctrine is trying to ensure a taxpayer entered into a transaction for a reason other than solely reducing tax liability and that its effect on the taxpayer includes something other than the mere tax effect.
There is currently a Circuit split between the DC and Sixth Circuit and the Third and Fifth Circuit on when the economic substance doctrine should apply. The DC and Sixth Circuit limit the use of the economic substance doctrine to situations where the tax provisions in question are open to debate or the text of the tax provisions in question reference economic substance. The Third and Fifth Circuit have applied the doctrine broadly allowing a court to unwind transactions even when a taxpayer followed the clear and unambiguous guidelines laid out in the Code provisions so long as the individual falls short on either of the two prongs of the doctrine.
IRC section 1211, the Code provision that allows for the harvesting of a tax loss, is short, clear, and does not reference the need for economic substance. Furthermore, our research did not find a single case applying the economic substance doctrine to IRC section 1211 (undoubtedly this is partially due to the wash sale rule). In almost all of the cases in which the economic substance doctrine has been applied elaborate schemes were devised by the individuals and corporations involved and the amount of money involved was substantial. Therefore, we believe it is highly unlikely that the IRS would apply the doctrine to an individual who harvests a tax loss from the crypto market correction. However, it is easy to envision scenarios where a nefarious taxpayer created an elaborate scheme to benefit from IRC section 1211. In that case, we would not be surprised to see the IRS take action under the economic substance doctrine.
Conclusion
An individual is clearly allowed to harvest a tax loss based on IRC section 1211. How the individual can redeploy the harvested losses back into the ecosystem is far from clear. Based on a strict interpretation of the Code, an individual could redeploy the harvested loss directly back into the same crypto asset. However, an individual invoking this strategy could have his/her loss unwound by the economic substance doctrine. If an individual wishes to be safe while harvesting his/her crypto loss, the individual could follow the guidance of the well-established wash sale rule. In between those two scenarios is a murky area of the tax law. The more nefarious and elaborate the scheme to harvest the tax loss, the more likely the IRS is to unwind the transaction. If you have any questions regarding the topics covered in this publication, please contact us.
