What Is The Crypto Wash Sale Rule & Why Should You Care?

Summary:

• A wash sale is a sale of a security or other asset where the investor repurchases the same asset within 30 days.
• The wash sale rule prohibits investors from claiming tax deductions on artificial losses incurred through a wash sale.
• This rule does not yet apply to crypto, which benefits crypto investors, but the US government is now actively trying to include cryptocurrencies under this rule.

What Is A Wash Sale?

A wash sale is a sale of a security or other asset where the investor repurchases the same asset within 30 days.

There are a few reasons why investors might enter into wash sales, one of which is for tax-advantaged reasons, such as to claim a loss on the original sale that can be used to offset other gains.

P.S  A wash sale is different from a wash trade. A wash trade is a type of trade where an investor buys and sells the same security on the same day in order to create the appearance of activity in the market. Wash trades are outrightly illegal as they can be used to manipulate the market.

What Is A Wash Sale Rule*?

This is why the wash sale rule exists–it aims to prevent investors from abusing “tax-loss harvesting” through a wash sale.

Tax-loss harvesting allows investors to reduce their tax burden by deducting capital losses from capital gains. That is, if you sell some securities at a $6,000 profit but sell others at a $4,000 loss, through tax-loss harvesting, you only need to pay tax on $2,000.

Investors can offset up to $3,000 from their personal income through tax-loss harvesting.

At the same time, it is also obvious why the authorities would not allow the uncontrolled use of this tax-lowering tool.

*This article focuses on practices that are valid for the US but which could potentially have an international effect.

Example of Wash Sale Rule

Let’s say you buy 10 shares of Company A at $100/share for a total of $1,000. After a few months, the stock price drops to $80/share. However, you have capital gains from other securities and want to reduce your tax liability.

Hence, you sell A shares on, say, May 15.

Tax-loss harvesting allows you to deduct the $200 you lost on shares A from your taxable capital gains. But to be eligible to do this, you must not have bought A shares (or a “substantially similar” asset) 30 days before that, or, you must not buy it back within 30 days after May 15.

(Source: Market Business News)

In other words, the wash sale rule prohibits investors from selling stocks at a loss and immediately repurchasing the same or substantially similar stocks.

This is intended to discourage investors from attempting to claim losses on their taxes that they have not actually incurred.

Does Wash Sale Apply to Crypto in 2022?

As of early September 2022, the wash sale rule still does not apply to cryptocurrencies in the US. This is because the IRS categorizes these assets as property to which the rule does not apply.

This is another feature that makes crypto an attractive choice for investors. They can offset taxes on capital gains by selling their position to lock in a capital loss and immediately repurchasing the same crypto.

Unfortunately, we appear to be getting closer to seeing this tax loophole closed.

Could a Crypto Wash Sale Rule Happen in the US?

The fact that crypto isn’t on the list of assets that fall under the wash sale rule is not the result of oversight or a mistake.

The simple reason is that when authorities created this part of the tax law, cryptocurrencies did not exist.

Although this article only focuses on the US, rules similar to the “wash sale rule” exist in many countries, and in some of them, they also apply to crypto.

Closing the Crypto Wash Sale Loophole

In 2021, the US Congress’s Joint Committee on Taxation shared that introducing a crypto wash sale rule could bring in $17 billion in the next 10 years.

This is part of a grand intention to rein in the crypto market, though the potential effect of such actions is still unclear.

Financial experts who monitor the situation say that major crypto regulations are likely still a long way off. For example, the US government has only just begun to explore how to regulate crypto.

Nevertheless, it’s best for investors to stay informed about how this process is progressing, due to its overarching impact.

Crypto Wash Sale and the Infrastructure Bill

In fact, 2021 was big for crypto not only because of the historical highs reached by some coins but also because of some policies that were launched back then. One of them concerns the colossal Infrastructure Investment and Jobs Act of Biden’s administration, which also affects crypto investments and their tax status.

This was also the year in which Biden introduced The Build Back Better Act to Congress, part of which is directly related to the crypto wash sale rule. It is this bill that should’ve extended the rule to cryptocurrencies as well. Although the bill won approval from the House of Representatives, the Senate could not reach a consensus. Thus, the wash sale rule does not yet apply to crypto at the time of writing.

Yet, let’s keep in mind Senate elections are coming up soon. Their result could be decisive for the future of crypto-related legislation. Last year expectations were that by today’s date, the wash sale rule should’ve already covered crypto as well. It remains unclear yet what will actually happen and how close we are to this policy actually happening.

Global Consequences of Crypto Wash Sale Rules

It’s time to explain why you should even care about wash sale rules if they don’t apply to crypto or you’re not American.

Decisions made by US legislators will set the tone for the rest of the world. Accordingly, every investor will be impacted, regardless of whether these rules directly affect them or not.

This can happen via the following:

Ripple effect of a wash sale rule in crypto

The USA and its partner countries may differ radically in certain legislative domains, but money-related policies have global implications. Thus, it’s expected that a US-led move towards stricter rules for cryptocurrencies will also have a ripple effect on other countries.

Not only that, but the European Union, one of the world’s largest economies, is also developing Markets in Crypto Assets Regulation (MiCA)—a set of regulations explicitly targeting digital assets.

It wouldn’t be surprising if a number of other countries followed suit by becoming more active in enforcing controls over cryptocurrencies.

Market effect of a crypto wash sale rule

A possible US extension of the wash sale rule to crypto assets will affect many US investors and their approach to crypto investing.

There are approximately 35 to 50 million crypto investors in the United States alone. Imagine what market power this is if even a fraction of them decide to change their investment approach based on the hypothetical scenario of having to deal with a crypto wash sale rule.

How Can I Avoid the Wash Sale Rule?

There are a few ways that you can avoid the wash sale rule.

1. One way is to simply wait more than 30 days before repurchasing the same or substantially similar security.
2. Another way is to purchase a different security that is not substantially similar to the one sold at a loss.
3. Finally, you can sell your securities at a loss and then use the proceeds to purchase a completely different asset, such as real estate.

Conclusion

The wash sale rule was introduced to limit potential abuses related to tax-loss harvesting, which is a tool that allows investors to reduce their tax liabilities by offsetting capital gains with losses.

The wash sale rule does not apply to crypto at the moment, but things are expected to change soon. In the meantime, it’s a good idea to keep an eye on what’s happening in this aspect.