Key takeaways
- Tax loss harvesting is the legal and intentional practice of recording capital losses
- Crypto tax losses can directly offset capital gains
- Cryptocurrency price volatility can create tax loss harvesting opportunities
If you’re a crypto trader or investor, then perhaps you’ve heard something about harvesting your crypto losses to lower your tax bill. Tax loss harvesting is the practice of intentionally taking a loss to offset a large capital gain at tax time.
The volatility of cryptocurrency prices makes tax loss harvesting especially relevant to many crypto holders. Keep reading to find out everything that’s most important about tax loss harvesting.
What is tax loss harvesting?
Tax loss harvesting is the practice of intentionally incurring tax losses to offset capital gains. Reducing your net capital gains in a given tax year reduces your investment income, which can lower how much you owe in taxes to the U.S. government.
You may be currently wondering—isn’t reducing your investment income a bad thing, even if you pay less in taxes? Digital token holders can take a mindful and selective approach to tax loss harvesting by only realizing losses on assets that are chronically underperforming or no longer wanted in an investment portfolio.
Let’s illustrate tax loss harvesting with an agricultural example. Imagine that you're a farmer with two fields. One field yields a bountiful crop, while the other field unfortunately floods and doesn’t produce anything but a rotten mess. Instead of lamenting the lost yield, you decide to use the rotting crop as compost for the next farming season. Tax loss harvesting is a lot like making compost—you're leveraging one type of financial loss to produce another type of financial gain.
Pros and cons of tax loss harvesting
Strategically incurring tax losses can enable crypto holders to lower their tax obligations, but that doesn’t mean that tax loss harvesting has zero drawbacks. Let’s better understand tax loss harvesting by exploring the pros and cons of this practice.
Pros of tax loss harvesting
There’s a lot to love about tax loss harvesting, especially for crypto traders and investors—
- Tax savings are immediate: Tax loss harvesting can reduce your tax liability in the current year.
- Ordinary income may be offset: Harvesting tax losses that exceed your capital gains may enable you to deduct some of those losses from your ordinary income.
- Potential for carry-forward tax benefits: Taxpayers with recognized losses that surpass both their capital gains and the allowable deduction against ordinary income can potentially carry forward the remaining losses to offset future capital gains in subsequent tax years.
- Opportunity to rebalance your investment portfolio: The practice of identifying and harvesting tax losses can provide an opportunity to reassess and rebalance your investment portfolio.
- Opportunity to reduce portfolio risk: Proactively selling underperforming assets to record tax losses can reduce the overall riskiness of your portfolio.
- After-tax returns may be enhanced: Regularly minimizing your tax liabilities through tax loss harvesting can boost your portfolio’s after-tax performance.
- Adaptability to market volatility may increase: Crypto investors who harvest tax losses may feel better equipped to adapt to volatile market conditions.
- Reinvestment may drive long-term portfolio growth: Crypto holders who reinvest the proceeds from asset sales associated with tax loss harvesting may use this practice to drive long-term portfolio gains.
Cons of tax loss harvesting
What are the drawbacks and risks associated with harvesting your tax losses? Let’s take a look:
- Higher transaction costs: Selling underperforming assets to realize capital losses can increase the transaction fees associated with your investment strategy.
- Potential for wash sales: Selling and repurchasing the same cryptocurrency within a short period of time—generally 30 days—can cause any loss from the sale to be disallowed from tax loss harvesting.
- You may miss market recovery opportunities: If you sell a cryptocurrency to recognize a capital loss, and the price of that cryptocurrency later recovers, then you may miss the opportunity to benefit from that price recovery.
- Portfolio management can get complicated: Harvesting tax losses is an advanced tax-minimization strategy that can require additional time or software resources to implement properly.
- Tax benefits may be limited: Tax loss harvesting generally doesn’t confer unlimited tax savings. Tax deductions and the ability to carry forward tax losses are usually limited.
Who should practice tax loss harvesting?
Traders, investors, and even enterprises can reduce their tax obligations by harvesting tax losses. Keep reading to better understand who can consider using this tax minimization strategy:
- Active crypto traders: Those who actively trade cryptocurrencies often realize both capital gains and losses. Active traders can harvest tax losses to offset capital gains.
- Investors with realized capital gains: If you’ve already recognized a significant capital gain during the tax year, then selling losing positions can lower your tax bill.
- Individuals in high tax brackets: High earners who harvest tax losses can potentially lower their taxable ordinary income. Tax savings from recognizing losses can be substantial for these individuals given their elevated tax rates.
- Long-term investors with short-term cash needs: Even buy-and-hold investors may have short-term liquidity needs. Harvesting tax losses is a tactical method to generate funding while minimizing the tax consequences.
- Investors wishing to rebalance their portfolios: Rebalancing your investment portfolio provides a natural opportunity to sell underperforming assets and recognize capital losses for tax purposes.
- Enterprises with fluctuating profits: Tax loss harvesting can help organizations with varying profits over time to manage their cash flows. Recognizing a substantial loss in one year can even confer tax benefits that carry forward into future years.
How to harvest your crypto tax losses
You may be wondering about exactly what you need to do to harvest tax losses. Let’s explore the basic steps:
1. Review your portfolio. Begin by examining your investment portfolio to refresh your memory about what you are holding.
2. Identify any loss positions. Determine the cost basis for each of your positions—perhaps by using crypto tax software. Compare the current market value of an asset to what you paid for it, and use that information to identify your losing positions.
3. Decide which assets to sell. Consider selling some or all of your holdings that have declined in value. Underperforming assets that don’t fit well with your current investment strategy can be excellent candidates for tax loss harvesting.
4. Execute the desired sales. Your next step is to sell the underperforming assets to realize capital losses in your portfolio.
5. Calculate your net capital loss or gain. At the end of the tax year, add all of your capital losses and capital gains to compute your net gain or loss for the tax year.
6. Accurately report your investment income. Your next step is to accurately report your income to the relevant tax authorities. Your net capital gain or loss determines the net impact of your investing activity on your taxes.
7. Carry forward excess losses to future tax years. Investors who harvest tax losses above certain limits or thresholds may be permitted to carry forward those losses to future tax years. Tax losses that are carried forward can directly offset future capital gains.
Beginner mistakes when harvesting tax losses
Nobody likes making mistakes, especially when money is involved. Keep scrolling to understand the most common pitfalls and mistakes associated with harvesting tax losses:
- Overlooking the potential for wash sales: Investors and especially active traders need to stay extremely organized to avoid inadvertently making wash sales that affect their ability to harvest tax losses.
- Ignoring transaction costs: Conducting transactions to record capital losses can boost your transaction fees—which beginner investors may be tempted to overlook.
- Disregarding your investment strategy: Making investment decisions based on the potential tax benefits, rather an investment strategy, is another beginner mistake.
- Neglecting portfolio balance: Harvesting tax losses without considering the overall balance of your portfolio can result in your portfolio becoming over- or under-weighted in a specific asset.
- Over-harvesting losing positions: Being over-eager to record tax losses can lead to selling assets that later recover or even gain significant value.
- Failing to monitor your entire portfolio: Successfully harvesting tax losses means accurately calculating the gains and losses across your entire portfolio, which may span multiple digital wallets or exchanges.
- Overestimating tax benefits: Beginners may miscalculate the potential tax benefits from harvesting tax losses or may misunderstand tax loss carry-forward rules.
How to learn more about tax loss harvesting
If you still have questions about tax loss harvesting, then you’ll want to keep researching to learn everything that you can about this tax minimization strategy. You have several different options to learn more about tax loss harvesting:
- Visit tax authority websites to gather information from credible sources
- Enroll in online tax and accounting courses
- Participate in digital investment forums and groups
- Read books about tax planning
- Subscribe to financial and tax newsletters
- Consult with tax and accounting professionals
Tax loss harvesting can be beneficial for many traders and investors—but it's also a nuanced strategy that requires careful consideration and attention to detail. You’re already on the right track by getting smart about tax loss harvesting—before making any portfolio decisions.
