Analysis: Crypto Tax Loss Harvest Szn
This article was written by Jason Schwartz
Tax losses can last even longer. But the U.S. tax system is realization-based, meaning you have to actually trigger your losses to use them.
This article summarizes some ways the average U.S. crypto investor can trigger losses before December 31st to minimize their tax bill. Keep in mind that this article is no substitute for individualized tax advice, and each taxpayer's personal circumstances could have a material impact on their tax consequences.
"But ser, I have no income to offset"
That statement is almost always false. Because we have a realization-based tax system, our taxable income doesn't necessarily bear a relationship to the value of our assets.
Below are some of the ways you might have triggered taxable income or gain this year:
Service payments. Salaries and other payments for services are taxed at ordinary rates on their U.S. dollar value when received, even if you converted them all into LUNA in April and held them through the ensuing crash.
ERC-20 airdrops. Under current IRS guidance, airdrops of fungible tokens are also taxed at ordinary rates on their U.S. dollar value when you have "dominion and control" over them. D&C can be the subject of its own article, but a good rule of thumb is that it exists when you have both the ability and intent to use or dispose of the tokens, regardless of when you actually exercise that ability.
NFT airdrops. The tax consequences of receiving an NFT airdrop are less clear than those of receiving an ERC-20 airdrop. As I've previously written, NFT airdrops might be "part of the package" of something else you purchased, might be a gift or might be deemed to have zero value under some other rationale.
DeFi staking. It's likely that DeFi staking rewards, like interest denominated in Aave aTokens, are taxed currently as ordinary income, just like airdrops of fungible tokens. It's less clear whether rewards that accrue "inside" a DeFi token, like Compound cTokens, are taxed on a current basis or merely figured into your gain or loss calculation when you sell. I made the argument for the latter treatment in a previous article.
Consensus-layer staking. The IRS believes that mining rewards are ordinary income when received, and seems to think the same treatment applies to consensus-layer staking rewards. But when Josh Jarrett sued the IRS for a tax refund on his Tezos staking rewards earlier this year, they gave it to him. Make of that what you will if you run your own node.
Token swaps. Token swaps trigger capital gain or loss. If you bought 1 ETH at $1,500 and swapped it for an NFT when ETH was worth $1,600, you triggered $100 of capital gain. If you then swapped the NFT for $1,000 worth of ETH, you triggered $600 of capital loss. The key here is that all tokens are valued in U.S. dollars at the time of their triggering events.
Making the most out of losses
You're taxed at a higher federal rate of up to 37 percent on ordinary income and short-term capital gains. Long-term capital gains are taxed at up to a 20 percent rate, or 28 percent in the case of collectibles. Collectibles might include some NFTs.
Most of your usable crypto losses are likely to be capital losses from token swaps. Capital losses offset capital gains and up to $3,000 of ordinary income each year. You can carry excess capital losses forward indefinitely. There are netting rules to determine which types of capital losses (long-term or short-term) get wiped out first, and you can read about those here (scroll down to "netting gains and losses") if interested.
Ordinary losses offset ordinary income unless they are miscellaneous itemized deductions. Miscellaneous itemized deductions are completely disallowed until 2026, thanks to the Tax Cuts and Jobs Act, which President Donald Trump signed into law. The only usable ordinary losses you're likely to generate in crypto are theft losses, which are pretty hard to strategize for.
Below I discuss the most common types of crypto losses, how they are triggered and whether they can reduce your tax bill.
Token sales. The most obvious way to trigger capital losses is to sell tokens you're holding at a loss, and if you want to retain exposure, buy them right back. Stock and bond investors have to wait 31 days to buy back, otherwise the tax code treats the transaction as a "wash sale" and pretends it didn't happen. But the wash sale rules don't apply to crypto, at least not this year (unless the crypto is "stock" for tax purposes, which, as I've previously discussed, is a possibility for some DAO governance tokens and tokens representing interests in pooled smart contracts). Some in Congress are trying to change that for future years, so it might make sense to trigger any capital losses you're sitting on now, even if they exceed your gains for the year.
Two notes of caution. First, the IRS can ignore transactions that lack economic substance. What lacks economic substance is a judgment call, but atomic token swaps (e.g., ETH to USDC to ETH in a single block) are unlikely to have economic substance.
Second, two assets have to be materially different in kind or extent to trigger a loss. So wrapping or unwrapping a token, or swapping a token for its wrapped or unwrapped version, probably doesn't trigger loss. On the bright side, it also probably doesn't trigger gain.
Theft. Thefts trigger ordinary losses that offset ordinary income for the year but can't be carried forward.
To generate a good theft loss, the theft probably has to be illegal and incurred in a transaction that you entered into for profit. Fat-fingering to an unknown wallet probably doesn't trigger a theft loss, just an unusable miscellaneous itemized deduction. Taxpayers with funds stuck on FTX or another exchange also are unlikely to incur a theft loss, at least until they can prove an illegal taking of property with no prospect of recovery or until the IRS issues guidance that specifically addresses their situation, as it did in 2009 for victims of Bernie Madoff's Ponzi scheme.
Abandonment. Abandonment losses are likely to be disallowed as miscellaneous itemized deductions. It's better to sell than to abandon.
Sending tokens to a burn address is probably abandonment, not a sale. It's less clear whether "selling" at a price that is less than your gas cost is really abandonment. NFT Loss Harvestooor lets you sell NFTs for 10 gwei (substantially less than a penny), and the CoinLedger team, which helped develop it, seems to think sale treatment would be respected, but there is no assurance that the IRS will agree.
Worthlessness. Worthlessness deductions are disallowed as miscellaneous itemized deductions. Try to sell your tokens before they actually go to zero.
One exception to the limitation on worthlessness deductions is for worthless debt. If USDT ever went to zero, holders might claim capital losses on the as-yet-untested theory that USDT is debt of Tether. The same argument wouldn't apply to Terra's UST, because algorithmic stablecoins aren't debt for U.S. tax purposes.
Customers suing Celsius have claimed legal ownership over the assets referenced in their accounts, instead of a mere unsecured claim against the exchange. If the bankruptcy court were to rule against the customers, they might be able to take a bad debt deduction on the theory that they had loaned money to Celsius and the loan became uncollectable, resulting in capital losses. That would be cold comfort for them because they'd probably prefer to get what's left of their tokens.
Conclusion
The soundest crypto tax strategy is to not trigger any income or gain. Short of that, try to trigger capital losses, which can offset capital gains and up to $3,000 of ordinary income. Theft losses can further reduce ordinary income.
There may be other ways to generate deductions, including by contributing to a retirement plan or giving to charity. Consult your accountant on these.
Above all, try to appreciate what really matters this holiday season: bags full of illiquid JPEGs. And family.