Taking advantage of fluctuations in digital asset values

The cryptocurrency market is deep into a bear market, or a “crypto winter,” but there is a silver lining — an opportunity for investors to take advantage of market volatility and reduce their 2022 tax liabilities.

Market conditions

The recent collapse of FTX, one of the world’s largest and fastest-growing cryptocurrency exchanges, has upended an already turbulent market. To say the last year has not been kind to digital assets is an understatement; cryptocurrencies are now off approximately 70% from their November 2021 highs. FTX’s failure is just the most recent in a series, as digital asset platforms face liquidity crunches from declines in cryptocurrency values and the May collapses of stablecoin TerraUSD and cryptocurrency LUNA.

Some unfortunate investors who stored their digital assets on an effectively defunct platform, such as FTX, are stuck in limbo, waiting to find out how many of their assets, if any, they will be able to recover, as the exchanges make their way through bankruptcy proceedings. But most digital asset owners, including those who want to stay invested in cryptocurrencies, have an opportunity to take advantage of the current market instability by harvesting tax losses. This strategy assumes taxpayers have capital gains by which they could offset their losses. For individual taxpayers without capital gains, these losses are only eligible to offset other income up to $3,000 per year with the balance carrying forward.

The taxation of cryptocurrencies

The IRS treats convertible digital currencies, including cryptocurrencies, as property, subject to the general tax principles applicable to property transactions. This means taxpayers recognize gain or loss on the sale or exchange of cryptocurrency. If the cryptocurrency is held as a capital asset, meaning taxpayers hold it for personal or investment purposes, any gain or loss would be capital in nature.

Digital asset investors who have seen a decline in the value of their holdings can, of course, sell and recognize a capital loss at any time. But what about those investors who have built-in losses but want to remain invested in cryptocurrency? They have an opportunity to recognize losses, also.

The ability to “wash sale” cryptocurrencies

For taxpayers who sell stock or securities at a loss and then purchase substantially identical stock or securities within 30 days, the loss on their sale is disallowed. The definition of “stock or securities” is not outlined in the statute other than to say it includes contracts or options to acquire or sell stock or securities. Generally, the rule has been interpreted as excluding cryptocurrencies, foreign currencies, and commodities. This provides taxpayers an opportunity to recognize built-in cryptocurrency losses while maintaining their investment. Note: This strategy may not be available to those holding their assets on exchanges undergoing bankruptcy proceedings, such as FTX or Celsius, as those assets will likely be frozen until such time as the bankruptcy court releases them.