By Nathan C. Goldman and Christina M. Lewellen
In July of 2022, Bitcoin, arguably the world’s most recognizable cryptocurrency, fell to below $20,000. This level marked a significant decline from its high of over $68,000 in November 2021. For most of the last several years, investors were interested in understanding the tax implications of their cryptocurrency holdings from the perspective of how their gains will be taxed. Now that cryptocurrency has declined in value, we turn our attention to the tax implications of cryptocurrency losses.
The Taxation of Cryptocurrency
Like our previous article discussed, the government taxes cryptocurrency as a capital asset, similarly to the taxation of sales of stock or commodities like gold. This departure from its namesake of a ‘currency’ seems a bit odd. However, cryptocurrency is not something that is freely traded for goods and services, nor does it maintain a steady price. Thus, its characteristics are much more aligned with a stock rather than a currency.
Consequently, the sale or exchange of cryptocurrency generates a gain or loss to the seller based on the difference between the purchase price and the sale price. For example, if cryptocurrency was purchased for $30,000 and sold for $40,000, then the seller would recognize a gain of $10,000 at the time of sale, and pay those corresponding taxes. However, if the cryptocurrency was instead sold for $20,000, then the seller would recognize a loss of $10,000 at the time of sale.
While a taxpayer must pay tax on the entire capital gain in the year of the sale, they cannot immediately deduct capital losses to the same degree. In general, capital losses cannot be used to reduce non-capital income and can only be used to offset other taxable capital gains. However, Section 1211 of the Internal Revenue Code allows individual taxpayers to deduct $3,000 of capital losses per year to offset other non-capital income. Otherwise, if the taxpayer has any capital gains in subsequent years, he or she can offset those gains with the capital losses. While there is a benefit to being able to offset ordinary income with capital losses, it often takes several years or realization of another capital gain for many taxpayers to recover the tax benefits of their losses fully.
What to do if the cryptocurrency is currently in a loss position
Taxpayers can consider three clear options that if they are holding cryptocurrency at a loss:
1. Continue holding. Cryptocurrency is volatile, and it is possible that its value eventually increases. For example, in 2021, Bitcoin traded at $61,000 in March, before falling to $31,000 in July, and back up to $68,000 in November. The U.S. tax code only taxes income once it is recognized, and thus, it does not tax these fluctuations. Thus, from a pure tax perspective, it does not cost the taxpayer anything to wait for the possibility that their cryptocurrency eventually increases in value.
2. Sell. While many investment gurus would recommend never sell low, it is not clear if this is the basement price for cryptocurrency. Thus, if an investor wants to unload their cryptocurrency, they should consider their inherent tax benefits for selling at a loss. To help illustrate this second point, let us consider a single taxpayer who has $100,000 of taxable income every single year, and this taxpayer recognizes a $12,000 loss on the sale of cryptocurrency in the year 2022. The U.S. tax code permits the taxpayer to deduct $3,000 of this loss each year. See below for how this loss affects the taxpayers income tax liability for 2022 and beyond:
| Without Capital Loss Deduction | With Capital Loss Deduction | ||||
|---|---|---|---|---|---|
| Year | Taxable Income | Estimated Tax Liability | Taxable Income | Estimated Tax Liability | Diff. |
| 2022 | $100,000 | $17,836 | $97,000 | $17,116 | $720 |
| 2023 | $100,000 | $17,836 | $97,000 | $17,116 | $720 |
| 2024 | $100,000 | $17,836 | $97,000 | $17,116 | $720 |
| 2025 | $100,000 | $17,836 | $97,000 | $17,116 | $720 |
| Total Savings | $2,880 |
In each year from 2022 to 2025, the taxpayer can deduct $3,000 from their ordinary income to lower their tax liability. Thus, while realizing a $12,000 loss is not ideal, if the taxpayer believes the drop in value will persist into the future, going ahead and selling the cryptocurrency at a loss can allow the taxpayer to generate the tax benefits now rather than later, which is preferential from a net present value perspective.
Lastly, cyrptocurreny currently does not have “wash sale” prevention rules. This notion allows taxpayers to sell a cryptocurrency, recognize the loss, and then immediately repurchase that same cryptocurrency, a feature that is not available for other capital assets.
3. Do Not Donate (Directly). As cryptocurrency boomed, many investors donated the cryptocurrency to reap the tax benefits associated with an asset that has appreciated so much in value. However, the same strategy should not be applied if the cryptocurrency is in a loss position. Donating cryptocurrency follows similar rules as those for securities. The U.S. tax code permits donations of securities like stocks or bonds at their fair market value. Thus, when the security is worth more than what it was purchased for, then the taxpayer can donate the security directly to a charitable organization and receive a deduction for the current value of the security while avoiding paying capital gains tax on the gain.
However, the same rules apply if the security is in a loss position, or in other words, the taxpayer will also forfeit the tax deduction for the capital loss upon donating. Thus, taxpayers who want to donate the asset should instead indirectly donate the assets to the charitable organization by selling them first (recognize the loss and be able to deduct it this year and in current years, and then donating the proceeds.
This post was in Poole Thought Leadership.
