Crypto taxes are back in the news. On Tuesday, President Joe Biden tweeted out an infographic that suggested that Congress should cut “Tax Loopholes That Help Wealthy Crypto Investors ($18 billion).”
The language had some in the industry scratching their heads: What’s the $18 billion loophole?
The White House did not clarify where the dollar figure originated, but it is likely related to harvesting tax losses in combination with wash sales.
You’ve probably done some harvesting of tax losses and not even known that you’ve done it. It’s a simple concept—you sell underperforming or losing assets, like stocks where the value has plummeted, to create losses to offset gains from appreciated assets. Selling stocks or other investments that are losers to offset gains from winners is referred to as harvesting.
The rules can be tricky, but typically you use losses to offset gains of the same kind (short-term gains with short-term losses, long-term gains with long-term losses). But if one kind of loss exceeds your gain of the same kind, you may be able to apply them to the other type. And if your capital losses for the year exceed your capital gains, you can deduct up to $3,000 in net losses from your total annual income. Beyond that, you can carry forward losses into the following tax years.
For tax purposes, a wash sale occurs when you sell or trade stock or securities at a loss, and then, within 30 days before or after the sale, you buy or acquire substantially identical stock or securities.
A substantially identical stock or security is precisely what it sounds like. You have a wash sale when you sell shares of a stock or security and then buy exactly the same stock or security. You can also end up with a wash sale if you sell shares of a stock or security and buy shares of stock or security of a related company, including predecessor or successor companies in a reorganization. The wash sale rules also apply to losses from sales or trades of contracts and options to acquire or sell stock or securities. Typically, the IRS looks at the facts and circumstances when determining whether a stock or security is “substantially identical.”
Why does it matter? Most taxpayers can’t deduct losses from sales or trades of stock in a wash sale—that makes any tax harvesting involving a wash sale somewhat useless in that tax year. While you lose the deduction, it’s not all bad—you can add the amount of the loss to the cost basis of the replacement stock or security which could be beneficial down the road.
No Wash Sales For Crypto
Wash sale rules don’t apply to every asset. They do not, for example, apply to losses from sales or trades of commodity futures contracts or foreign currencies. And, notably, they don’t apply to digital assets. That’s because digital assets, including cryptocurrency, don’t meet the definition of a stock or security in the statute or Regs.
You can already see where this is going. If you can offset gains with losses, that can be tax advantageous. And—without any pesky wash sale rules—if you have a losing asset, you can sell it off at a low point to take advantage of the loss and turn around and rebuy it.
That could change. President Biden’s proposed budget for the 2024 fiscal year includes a proposal to make digital assets subject to the wash sale rules, aimed at “closing a loophole that benefits wealthy crypto investors.”
Specifically, the proposal would require that “the same loss recognition rules should apply to digital assets held as investments or for trading as would apply for stocks and securities.” The term “digital asset” would generally mean “any digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar technology as specified by the Secretary.”
If you feel like you’ve heard that before, you’re not wrong. The initial 2021 Build Back Better Act bill included similar provisions that weren’t included in the replacement Inflation Reduction Act.
The rule, if made law, would take effect in 2024. The administration estimates the change would bring in $1.24 billion in 2024 and $8.97 billion over the next five years. From 2024-2033, the estimated boost to revenue is $23.52 billion.
(The budget also includes a premium for energy consumption used in cryptomining. You can read more about it here.)
The $18 Billion Question
That’s still not $18 billion. So where is it coming from?
A 2022 National Bureau of Economic Research (NBER) working paper found that increased scrutiny on crypto has caused the markets to move faster. Specifically, they found that “in particular, domestic traders increase tax-loss harvesting following the increase in tax scrutiny, and U.S. exchanges exhibit a significantly greater amount of wash trading.” That’s because—as noted above—it’s easy to offload crypto, take a loss (used to offset gains), and then quickly buy it back.
Looking at the tax year 2018, with an assumed tax rate of 30%, the authors of the paper estimated the tax revenue loss due to the absence of wash sale rules to be between $10.02 and $16.2 billion. Of course, there wasn’t a 30% rate in the U.S. In 2018—as now—the tax rates were 0%, 12%, 22%, 24%, 32%, 35%, and 37%—but you get the point.
Models are great, but I don’t know that anyone can say with certainty how much revenue might be brought in by subjecting cryptocurrency sales to the wash sale rules, though I think we can all agree that it would be significant.
An even bigger question? Whether the proposal makes it through the current Congress. That remains to be seen.