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What’s the Cryptocurrency Wash Sale Rule?

Mar 2, 2023

What’s the IRS Wash Sale Rule?

Let’s begin with a general definition of a wash sale. A wash sale is a transaction selling/trading security below the cost basis and purchasing the same or equivalent asset 30 days before or after the sale.

The Internal Revenue Service (IRS) wash sale rule prevents investors from misusing a wash sale at the end of the year to reduce taxes. This rule is valid for securities and trading assets such as stocks, options, contracts, etc.

Here’s an example. We’ll use BTC instead of stocks. Let’s say John gained $40,000 and had $5,000 in losses as of December 31. The resulting gain then totals $35,000. But John also has 1 BTC with a cost basis of $30,000 and a current fair market value of $20,000.

He decides to sell 1 BTC and gets $20,000 for that. The loss is $10,000. On January 10, John purchased 1 BTC for $21,000. It allows John to indicate $10,000 as a loss when he does his taxes report and use it as gains offset.

Instead of reporting a total gain of $35,000, he provides a different number – namely $25,000 ($35,000 – $10,000 lost in BTC sale) while, in fact, John still has this 1 BTC and spent $1,000 to rebuy this asset. After all these actions, John reports fewer taxes without losing that much money.

The sale wash rule was created to avoid such unfair actions. The 30 days before the stock sale or purchasing prevents taxpayers from abusing the opportunity to reduce taxes due to losses associated with the asset sale. This loss is considered artificial. No matter if you sell crypto at the end of the year and repurchase it in early January. The rule keeps its power, and such an action is still considered a wash sale. The only way to claim loss is after repurchasing it 30 days after or before selling it at a loss. The rule remains in force if the asset is repurchased not by an initial holder but by their spouse or a company.

Also, it would be best if you kept in mind that a wash sale is not illegal. You can buy and sell whatever assets at any time you like. The only thing that conflicts with the rule is trying to reduce your taxes liability via the aforementioned wash sale scheme.

There is no severe penalty for a violation of the wash sale rule. The only immediate outcome is your attempt to reduce taxes will be disallowed. If you want the losses to be considered when the taxes are calculated, you will have to sell the security.

But does this rule apply to cryptocurrency? We’ll answer this question below.

Does Wash Sale Apply to Crypto?

As of the time of writing this article (February 2023), the crypto wash sale rule doesn’t exist. Nevertheless, ignoring this rule can do you a disservice. Currently, cryptocurrencies are seen by the IRS as property, not a security, but if this changes, a wash sale may not play out well.

As long as the IRS does not consider cryptocurrencies as securities, you can use rebuying crypto assets following the losses associated with these assets for tax reduction. However, you should approach such practices with caution. The wash sale rule applies to the stocks of the companies involved in crypto. Before you use the crypto associated with these companies for a wash sale, it’s better to contact experts for advice. Another reason for additional caution is that the cryptocurrency regulation is in progress, and you can easily miss the moment when the rules change for crypto.

However, there are ways for a more straightforward wash sale. For instance, you can rebuy the asset you have sold to a loss after the 30-day period. It won’t violate any rules. Another method is exchanging a token whose price is on a downward track for a better coin with a similar price. You can hold a stronger coin for 30 days and then finally trade it for an initial asset.

Could a Crypto Wash Sale Rule Happen?

Without a doubt, the emergence of the wash sale rule for cryptocurrencies is somewhat a matter of time. A House Ways and Means Committee dedicated some time to developing such a rule in 2021. The project didn’t make it in Congress, but we have all reasons to believe that the crypto wash sale rule will become a reality after a while. People have already been working on it for several years.

In March of 2022, POTUS Joe Biden signed the bill that empowers federal agencies to focus more on cases of crypto wash sales. The changes in legislation on the topic will not likely keep us waiting for a long time. That’s the reason for double-checking all your actions that can be regarded as an attempt at a crypto wash sale. Get ready for a new legal reality, and don’t put yourself in a weak position. If you are not sure about something, contact someone who can give you advice.

How to Avoid Wash Sale Rule Violations?

As mentioned above, there are several ways to avoid violating the wash sale rule. The general advice here is just not to rebuy the asset sold to a loss within a 30-day period. That’s it. If you have the guts to wait enough, you will avoid the potential hassle associated with a wash sale simply because after a 30-day period, this transaction won’t be considered a wash sale.

If you don’t want to count days, don’t rebuy an asset you sold at a loss in the current and the next month. This will be enough. For instance, if you sell the coin in March, don’t rebuy it in March and April.

Another strategy is replacing the coin you are selling at a loss with a different coin that currently has a similar price. Just hold this second currency for 30 days and repurchase the original asset when the time is right.

If you want to use crypto to offset gains, buy more tokens of crypto you are going to sell at a loss, and sell all these coins after a 30-day period. There is a chance you will sell everything at a more significant loss. Probably that’s what you strive for.

Conclusion

Cryptocurrency regulation is not standing still, although it may seem its development is pretty slow. As of February 2023, the IRS doesn’t see cryptocurrencies as security and doesn’t apply the wash sale rule to digital money. However, this article probably won’t age very well in just a few months from now.

You should keep your finger on the pulse and follow the news on the topic. Otherwise, you may miss an important moment when the wash sale rule becomes valid in the cryptocurrency world. As officials and even the POTUS himself are interested in the topic, we will undoubtedly see a change in the legal status of a crypto wash sale whether you like it or not.

However, until crypto wash sales are not banned, you can take advantage of this loophole if you act smartly and with caution. We are not summoning you to do so, but we can’t tell you the opposite either. We only inform you of the current position of affairs.

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