Cryptocurrency Tax War, Part II

Do you trade bitcoin and ethereum? You’d better know about wash sales, constructive sales and straddles.

The first part of the assault on virtual currency has the Internal Revenue Service going after tax cheats—successful traders who neglect to pay tax on their gains. It involves threatening letters, grabs of customer records from exchanges and, no doubt, plans to make a public example some day of a big offender.

The second part of the crypto war targets honest investors. The government wants to make it harder for you to claim a loss and easier for you to be forced to declare a gain.

Part II is, for the most part, a work in progress. The tax increase under debate in Congress would extend the rules on wash sales and constructive sales, which now apply only to things like stocks and bonds, to other investments like commodities, currencies and digital assets. This article will define those two tax objects and spell out defensive maneuvers.

It is an open question whether the Biden administration can pull together the votes for a tax hike intended to raise $2 trillion over a decade. But it is quite likely that the crackdown on crypto will sooner or later find its way into the statute books, simply because crypto players are perceived as benefiting undeservedly from existing tax law.

Says Mark Fichtenbaum, a CPA, lawyer and professor at Pace University: “There’s been too much publicity [about the loopholes] in magazines like yours.” In short, even Republicans might sign off on a crackdown, as they did recently with inherited IRAs. It pays to be prepared for a tougher go on your 1040.

The battle between congressional tax writers and clever investors goes back a century, to Section 1091 of the tax code, the wash sale rule. This law says you can’t deduct a capital loss on a stock if you buy the stock back near the time of your loss sale. More precisely: Your loss is suspended if you buy replacement shares within a 61-day window beginning 30 days before the loss trade.

Example: You buy 100 Tesla at $800, see it drop to $600, and want to claim a $20,000 capital loss while maintaining your exposure so that you don’t miss a rebound. If you double up the position and then sell the original shares a week later, you can’t claim a loss on them. Instead, the $20,000 gets added to the cost of the replacement shares; the effect is to leave you where you would have been if you had stood pat.

Under present law, the wash sale rule does not apply to cryptocurrencies. And that means cryptocurrency investors can turn the considerable volatility in their market into immediate tax benefits. They can periodically book tax losses on recent purchases without really altering their position.

Enjoy this feature of crypto while you can. If you aren’t already harvesting losses from a crypto portfolio, start now. The pending tax bill would apply the wash sale limitation to trades…