The volatility of cryptocurrencies is nerve-wracking, and it may not be over yet. The turmoil may make crypto investors and crypto-related businesses less enthusiastic than when prices seemed to have been climbing. As the market falls off a cliff, your taxes will suffer hugely, right? unnecessary. With your dollar wobbly in the digital world, it’s worth asking if there’s any lemonade you can make by claiming your tax losses.
First, ask what’s going on from a tax perspective. If you’ve been trading and triggered a large taxable gain, but then the floor falls, first consider whether you can pay tax on the gain you’ve already triggered this year. Taxes are annual, usually based on the calendar year, unless you choose appropriately otherwise. Start with the proposition that every time you sell or exchange a cryptocurrency for cash, another cryptocurrency, or a good or service, that transaction is considered a taxable event.
This is what the IRS announced globally in Circular 2014-21, when the IRS declared cryptocurrencies to be property for tax purposes. Not currency, not securities, but property, so most transactions mean the IRS wants you to report profit and loss.
Related: What to Know (and Fear) About the New IRS Crypto Tax Report
Before 2018, many cryptocurrency investors claimed that cryptocurrency-to-crypto transactions were tax-free. But that argument is based on Section 1031 of the Tax Code. This is a good argument, depending on the facts and reports. But that claim has disappeared since 2018. Section 1031 of the Tax Code now states that it only applies to real estate swaps.
The IRS is auditing some pre-2018 crypto taxpayers, and so far it doesn’t seem to like the 1031 argument even before 2018. The IRS even issued a guide saying that tax-exempt cryptocurrency exchanges don’t work. If the IRS pushes it that far, we might need a court case to settle it. After all, it only applies to 2017 and previous years, so its importance is waning.
But whether you use cryptocurrency to pay someone, exchange cryptocurrency or sell it outright, do you gain or lose? For most people, gains or losses will be subject to short- or long-term capital gains/losses, depending on the underlying (what you pay for the cryptocurrency), the holding period, and the price at which the cryptocurrency is sold or exchanged. However, some may have ordinary gains and losses, and this topic deserves to be revisited. Do you trade cryptocurrencies as a business?
Related: Major tax myths about cryptocurrencies debunked
Most investors want a long-term return on capital if they buy and hold for more than a year. However, the ordinary income treatment may help some people, at least the loss. Securities traders can conduct Section 475 mark-to-market elections under the tax code, but does that work for cryptocurrencies? It’s unclear. To qualify, it must be argued that cryptocurrencies constitute securities or commodities.
The SEC believes that some cryptocurrencies are securities, and there may also be an argument for commodity characteristics. Worth considering at least in some cases. However, in addition to establishing the position that digital currencies are securities or commodities, you also need to be a trader to conduct mark-to-market elections. Whether a person’s activity constitutes a “transaction” rather than an “investment” is a key issue in determining whether a person is eligible for mark-to-market elections.
The IRS lists detailed information about who the trader is, often characterized by high trading volumes and short-term holdings, although sometimes investing and trading can appear very similar.
If a cryptocurrency eventually qualifies for mark-to-market, and you qualify and choose it, you can mark-to-market your securities or commodities on the last business day of the year. Any gain or loss will be ordinary income, as well as gain. One benefit is that there is no need for a tedious process to track the date and time each cryptocurrency was acquired and identify which cryptocurrency you sell.
For most people, this election (if there is one) probably means nothing, but as with many other things in the crypto tax world, there is a lot of uncertainty. In the past, some declines in the value of cryptocurrencies have been referred to as “flash crashes,” an event in the electronic securities market in which the withdrawal of stock orders rapidly amplifies price declines and then quickly recovers. In the case of stocks, the SEC voted on June 10, 2010 to create a rule that automatically halts trading in stocks in the S&P 500 that change in price by more than 10% in any five-minute period.
A stop-loss order instructs the broker to sell at the best price available if the stock reaches a specified price. Some people use the same idea for encryption. Some people even want to buy back the cryptocurrency after the sale, and with cryptocurrency, you can do that. In contrast, stocks have a wash-sale rule that limits selling (triggering losses) and buybacks within 30 days. Cryptocurrencies have no wash rules, so you can sell your crypto and buy it right away without the 30-day waiting period.
This article is for general informational purposes only and is not intended and should not be considered legal advice.
The views, thoughts and opinions expressed here are solely those of the author and do not necessarily reflect or represent the views and opinions of Cointelegraph.
Robert W. Wood is a tax attorney representing clients worldwide in the San Francisco office of Wood LLP, where he is the managing partner. He is the author of numerous tax books and frequently writes about tax for Forbes, Tax Notes, and other publications.