Bitcoin Holders Have a Few Months to Take Advantage of a Tax Loophole That Could Go Away in 2022

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  • The House Ways and Means Committee is trying to shut down one of the most lucrative crypto tax loopholes.
  • With crypto tokens, wash sale rules don't apply, meaning that you can sell your bitcoin and buy it right back, rather than waiting 30 days.
  • The existing rule helps crypto investors when its comes to tax-loss harvesting.

The House Ways and Means Committee is trying to shut down one of the most lucrative crypto tax loopholes, a move that could cost holders of bitcoin and other virtual coins nearly $17 billion, according to an estimate by the Joint Committee on Taxation.

The bill would apply the so-called wash sale rule to digital assets, according to a summary report by the committee, treating them like stocks. The rule forces an investor to wait 30 days between the selling of a security and the repurchasing of it, when a tax deduction is involved.

It's one of the tax hikes Democrats are considering as a way to fund President Biden's $3.5 trillion in proposed spending to expand the U.S. social safety net. While Democrats face many hurdles to finalizing legislation and getting it passed in a deeply divided Congress, crypto experts are already looking at ways to help investors minimize their 2021 tax.

Should the proposal pass, taxpayers have until Dec. 31, to take full advantage of the existing loophole, which allows crypto investors to sell coins at a loss for tax purposes and immediately buy them back. Given the recent plunge in crypto prices — the market is down 26% from a record in May — the timing is ripe for tax-loss harvesting.

Minimizing your 2021 crypto tax bill

The IRS currently classifies digital currencies like bitcoin as property, so losses on crypto holdings are treated much differently than for stocks and mutual funds.

"One thing savvy investors do is sell at a loss and buy back bitcoin at a lower price," said Shehan Chandrasekera, head of tax strategy at crypto tax software company "You want to look as poor as possible."

Chandrasekera added that investors can take advantage of an unlimited amount of losses and "carry them forward into an unlimited number of tax years."

The bigger the market for cryptocurrencies, the more this happens.

"I see people doing this every month, every week, every quarter, depending on their sophistication," Chandrasekera said.

Accruing these losses is how investors ultimately offset their future gains and lower the capital gains tax that would apply for other assets. In other words, they reduce what they owe to the IRS.

Quickly buying back the cryptos is another key part of the equation. If timed correctly, buying the dip enables investors to catch the ride back up, assuming there's a rebound. Digital coins are notoriously volatile, with steep drops often followed by rapid spikes.

Here's an easy way to the think about the equation. Someone who purchased one bitcoin for $10,000 and sold it for $50,000 would face $40,000 of taxable capital gains if bitcoin were like stock in Apple or Tesla. But, because of the wash sale loophole, if this same person had previously harvested $40,000 worth of losses on earlier crypto transactions, they'd be able to offset the tax they owe.

Chandrasekera said it's an increasingly popular strategy among his company's customers, but he cautioned that thorough bookkeeping is essential.

"Without detailed records of your transaction and cost basis, you cannot substantiate your calculations to the IRS," Chandrasekera said.

What might change

The wash sale rule would take effect Jan. 1. But to get there, it has to be included in legislation that passes the House and the Senate.

Chandrasekera is betting the rule makes it into the final bill because it aligns with crypto being treated as a security subject to 1099-B reporting," like other investments, he said.

But as it's written, the rule would not be applied retroactively, so crypto investors have a window available to take advantage of asset sales.

"Taxpayers can still reduce their 2021 tax bill, but they only have a few months left to do that," said Chandrasekera. "With the market down the last two weeks, it's great timing."

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