Lost crypto last year? There is a tax upside to your disadvantage

by Arthur · April 4, 2023

Want help with your crypto treasure? Check out The Decrypt 2023 US Tax Guide. It’s free and there’s a fun quiz at the end so you can receive a free proof of knowledge in the form of an NFT.

While everyone buys investments with the belief that they will increase in value, no one has a perfect investment record. This is especially true in the crypto investment sector due to its remarkable volatility compared to more established asset classes. This has led to some early crypto investors becoming extremely wealthy.

While these successful investors draw positive attention to this market with viral articles about their investment returns, every market – and trade – has two parties: a winner and a loser. While there aren’t many benefits to “buy high, sell low,” we break down how loss of crypto investment can become a partial gain through a process called tax-loss harvesting.

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Upside to a downside: Harvesting crypto losses

One benefit of seeing your crypto investments in the red (being worth less than your original purchase price) is the ability to sell those investments at a loss to reap capital losses that can be used to offset – or lower – your tax liabilities. When an asset is sold at a loss, you can deduct part or all of this loss from your tax. This is what is referred to as tax-loss harvesting.

The process for claiming crypto capital losses on litecoin (LTC), bitcoin (BTC) and other digital assets is the same process one would use to claim capital losses on stocks, commodities or other current investments. This is why strategic selling of crypto (or any asset) at a net loss is often used by savvy investors and recommended by savvy tax advisors.

Considerations when harvesting crypto losses

One thing to know is that the Internal Revenue Service (IRS) requires you to report all crypto sales. As the IRS considers crypto “property”, these sales must be reported in order to properly file your annual tax return. It doesn’t matter if these sales are profitable or not; The IRS wants to know about every crypto asset sold. Since this is already a reporting requirement, it is in your best interest to understand how these unprofitable sales can be improved through tax loss harvesting. To comply, you must complete Form 8949 and a 1040 Schedule D. You list your crypto sales—both profitable and unprofitable—on Form 8949. The 1040 Schedule D shows both short-term and long-term capital gains and losses. If you have accumulated losses from previous years, include those losses on this form as well.

Another important factor is deciding how you want to harvest these losses. There are two options; you can do this through tax deductions or by offsetting the capital gain. Offsetting capital gains is relatively simple. You can reduce any capital gains tax by deducting capital losses to lower your tax bill. For example, let’s say you sold some Tesla shares (TLSA) or BTC for a net gain and some Ether (ETH) for a net loss during the same calendar year. You can use your ETH losses to lower your TLSA or BTC profit tax. You will also have the option of offsetting capital gains in future years if you carried these losses forward.

In some cases, you can also deduct capital losses from income tax. If you don’t have capital gains to offset a capital loss, you can deduct this loss from your income to reduce the amount of earned income and thus reduce your tax liability. If you have capital gains offset, you cannot offset earned income.

One of the most important things to know when it comes to harvesting crypto losses is that there is an upper limit to how much you can harvest each year. At the time of writing, the amount you can write off for crypto losses is limited to $3,000 dollars per year. If you lost more than that, those losses can be rolled forward and used up to the maximum amount until the total loss is harvested.

Let’s look at a simple example:

Investor XYZ had an annual income of $75,000 and had a bad year with crypto capital losses, also totaling $75,000. This investor also had no capital gains to offset those losses. This investor could not claim all $75,000 in losses in one year and pay no income tax – although they might wish they could. They would only be able to reduce their earned income to $72,000 to pay taxes on that amount. In this scenario, with no other variables changing, they would be able to reap $3,000 in capital losses for 25 consecutive years.

Some investors make the decision to take the loss on an investment to reduce their capital gains for that tax year. CryptoTaxCalculator offers a tax loss harvesting tool that shows the loss that would have been reaped if these assets were disposed of during the tax year, helping investors make an informed decision and create a more favorable tax outcome.

How to deal with crypto disasters, hacks and thefts

You may have lost some – or all – of your crypto investments because of one hack, social engineering fraudor other theft. According to the current tax law, these losses are treated as investment losses and not casualty losses. Complete losses under these circumstances will be treated as $0.00 income transactions on Form 8949. Let’s look at an example. You bought ten bitcoin cash (BCH) at $300 per coin for a total of $3,000. Because of a crypto exchange hack, you no longer have access to your BCH. You will be able to claim a loss of $3,000 on your original investment.

Whether you experienced the hardships of a hack or simply had to sell for a loss, it’s worth understanding how tax-loss harvesting strategies can be used to maximize after-tax investment returns.

Reputable tax software, such as CryptoTaxCalculator, can flag stolen, lost or hacked assets and list them on your tax forms for you.

Cheat Sheet:

Crypto investments that are sold for a net loss can be used to offset or lower your tax liabilities through a process called tax-loss harvesting.
The process for claiming crypto-related capital losses is the same process one would use to claim capital losses on stocks and other current investments.
You can offset your losses by either offsetting the capital gain or through applicable tax reductions.
Annual capital losses are limited to $3,000 per year. Losses above this annual amount can be carried forward and used in future years.
Crypto lost as a result of hacking, fraud or theft can also be claimed as a capital loss and treated as an investment loss.

Disclaimer: This crypto tax series is for informational purposes only and should not be considered legal or tax advice. Please seek the services of a crypto-savvy accountant, tax professional or attorney if you require further guidance.