By Joe Dyton, WCI Contributor

When we hear the term “tax-loss harvesting,” it’s fair to assume it’s in reference to the cash we put into our investment portfolios. And while tax-loss harvesting does apply to the traditional money used to purchase stocks, bonds, and real estate, did you know this practice can apply to cryptocurrency like Bitcoin, too?

Yes, if Bitcoin is part of your investment portfolio, you can use any losses you suffered over the financial year to lower your capital gains and tax bill—legally. Just like with cash, however, there are rules you’ll have to follow if you decide to implement this strategy. Still, abiding by some rules seems like a small price to pay to help ensure any cryptocurrency-related downturns in your portfolio aren’t a total loss.

Keep reading to learn more about tax-loss harvesting, Bitcoin, and how you can effectively and legally tax-loss harvest with Bitcoin.

 

What Is Tax-Loss Harvesting?

Tax-loss harvesting is the practice of selling poorly performing investments at a loss and then using those losses to offset gains you made with your other investments. The money made from the sale is used to acquire a similar (but not identical) investment, keeping you invested in the market. The purpose of tax-loss harvesting is to be able to report a loss to the Internal Revenue Service (IRS) on your taxes and offset gains from your better-performing investments and your regular income for income tax purposes. The IRS permits you to deduct up to $3,000 per year of a short or long-term capital loss from your ordinary income on your taxes.

 

What Is Bitcoin?

Bitcoin is a type of digital currency that is independent of banks and governments. It differs from traditional currencies, such as the US dollar, which has value due to governments controlling their supply as well as laws against counterfeiting money. Meanwhile, Bitcoin uses what’s known as blockchain—an online ledger that can update and monitor itself, show how many Bitcoins every user has, and show who has sent and received Bitcoin.

Bitcoin transactions are made on a decentralized network. Individual Bitcoins are a digital asset that are stored at a cryptocurrency exchange or in a digital wallet. Each coin represents Bitcoin’s current price. When Bitcoin is transferred, network computers review the transaction, and if it looks legal, it can move forward. The transaction is recorded in the blockchain ledger for future reference.

More information here:

A Neurologist’s Road to Becoming a Bitcoin Maximalist: Why Bitcoin Is Not the Next AOL

Top 7 Uses for Bitcoin

 

How Tax-Loss Harvesting with Bitcoin Works

Tax-loss harvesting with Bitcoin shares many of the same principles as using the practice with traditional currency. You can acquire capital gains from selling, spending, or trading Bitcoin, but you’ll have to pay capital gains tax if you do. If you want to try to avoid that tax (or at least lower it) and you have a Bitcoin loss in your portfolio, you can apply a tax-loss harvesting strategy. Just sell, swap, or spend the poorly performing Bitcoin and use the capital loss to offset your gain. You not only avoid paying a capital gains tax, but you might be able to purchase back the cryptocurrency you just tax-loss harvested.

 

How to Tax-Loss Harvest with Bitcoin

As an example, let’s say you purchased a form of cryptocurrency for $2,000 and its price increased to $4,000. That’s a decent profit you made on that crypto, but if you sell it for $4,000, you’ll have to pay capital gains tax on that $2,000 return on investment.

Without tax-loss harvesting, that is.

To reduce or avoid that capital gains tax, you’d have to find an underperforming Bitcoin in your portfolio. Say you purchased one for $20,000, but it’s now valued at $18,000—a $2,000 drop. You could sell that Bitcoin that’s lost value and use that $2,000 capital loss to offset your $2,000 capital gain from the winning cryptocurrency to avoid paying capital gains tax on your profit.

 

Rules for Tax-Loss Harvesting with Bitcoin

Again, it’s legal to tax-loss harvest with Bitcoin, but you must operate within certain guidelines. For example, you can deduct up to $3,000 of cryptocurrency-related losses against your ordinary income. Losses exceeding that amount must be put toward future years.

Be mindful of what the IRS considers “taxable events.” Bitcoin transactions that could be taxed include selling digital assets for fiat currency, trading one type of cryptocurrency for another, and using Bitcoin to buy things. These are all examples of taxable events to keep in mind as you plan your tax-loss harvesting strategy.

Tax-loss harvesting with Bitcoin mirrors doing the practice with traditional currency in a lot of ways, but there’s currently a key difference. The wash sale rules that are in place for tax-loss harvesting with stocks, bonds, etc., don’t apply to cryptocurrency—for now. This could change depending on legislation shifts, so stay on top of regulatory developments.

If cryptocurrency were to become subject to wash sale rules, you couldn't sell Bitcoin as loss and then buy the same coin again (within 30 days) and still claim a loss for tax-loss harvesting purposes. The IRS established wash sale rules to prevent investors from artificially increasing their losses.

More information here:

Is Tax-Loss Harvesting Worth It?

 

Benefits of Tax-Loss Harvesting with Bitcoin

Tax-loss harvesting with Bitcoin (or other forms of cryptocurrency) that allows you to pay less capital gains tax is a huge benefit of this practice, but it’s not the only one. You can also offset up to $3,000 annually in capital losses against your regular income. Doing so lets you decrease your overall tax responsibility. Plus, additional losses aren’t wasted—you can push any losses above that $3,000 limit against gains in upcoming financial years, lowering your future tax bills.

 

Downside of Tax-Loss Harvesting with Bitcoin

While tax-loss harvesting can help keep down your tax obligation, it’s not without its disadvantages. The biggest one is potential costs. If you’re consistently making Bitcoin sales and purchases, you could be racking up transaction fees that exceed your tax savings. Monitor those fees along with your capital gains and losses to ensure you’re coming out ahead with tax-loss harvesting.

There’s also a chance that if you sell and then buy back Bitcoin, you could be looking at a larger capital gains tax bill in the future, depending on the asset’s value going forward.

 

The Bottom Line

Just like with traditional investment portfolios, tax-loss harvesting with Bitcoin can be a great (and legal) tool to reduce capital gains and your overall tax liability. It can also make your cryptocurrency portfolio more efficient. If you decide to move forward with this practice, be sure to pay attention to transaction fees, stay mindful of rule changes, and do not hesitate to speak with a tax professional to address any inquiries you may have.

The White Coat Investor is filled with posts like this, whether it’s increasing your financial literacy, showing you the best strategies on your path to financial success, or discussing the topic of mental wellness. To discover just how much The White Coat Investor can help you in your financial journey, start here to read some of our most popular posts and to see everything else WCI has to offer. And make sure to sign up for our newsletters to keep up with our newest content.