Key takeaways
- Selling your losing crypto positions may enable you to harvest tax losses
- Selling profitable crypto assets may support harvesting tax gains
- Harvesting tax losses or tax gains should align closely with your investing goals
To harvest tax losses or tax gains? If that is your question, then you’ve arrived at the right place. Tax loss harvesting is the practice of incurring capital losses to offset or eliminate capital gains, while tax gain harvesting is a strategy that involves recognizing capital gains when your tax rate is attractively low.
Cryptocurrency investors may benefit from both tax loss and tax gain harvesting. The volatility of the markets for digital assets creates plenty of opportunities to record gains and losses, which investors can potentially leverage to reduce or minimize their tax liability. Keep scrolling to understand all the nuances of tax loss harvesting versus tax gain harvesting, and find out the questions to ask when choosing between these tax minimization strategies.
What is tax loss harvesting vs. tax gain harvesting?
Tax loss harvesting and tax gain harvesting are both strategies used by investors and traders to reduce or eliminate their tax liabilities. Let’s define each of these approaches to tax optimization:
- Tax loss harvesting: Harvesting tax losses is the practice of intentionally incurring capital losses to offset capital gains. Reducing your net capital gains in a given tax year reduces your investment income, which may lower how much you owe in taxes to the U.S. government.
- Tax gain harvesting: Harvesting tax gains is the practice of intentionally incurring capital gains in a year when your tax rate is low to minimize your tax burden. Tax gain harvesting is a strategy that considers both your current and projected capital gains tax rates.
Harvesting a tax loss is a lot like returning a product that doesn't meet your expectations to get a refund or store credit. Tax gain harvesting is like pruning a fruit tree at just the right time to optimize the quality and quantity of its future yield. Both strategies can be effective to enhance the performance of your digital assets portfolio.
How do tax loss and tax gain harvesting work?
You may be wondering about how tax loss and tax gain harvesting work. Harvesting tax losses is possible whenever you have losing investment positions, while harvesting tax gains is an option if you’re holding assets that have gained value.
Let’s first explore the steps to harvest tax losses:
1. Review your investment portfolio: Start by examining your portfolio, which may hold only cryptocurrencies or a mix of traditional and digital assets. Identify which of your assets have lost value since you purchased them—these are your potential candidates for tax loss harvesting.
2. Choose assets to sell: Your next step is to determine which of your unprofitable investment assets, if any, that you want to sell. Any decision to sell an asset should align with your long-term investing goals and not just be based on this year’s tax considerations.
3. Execute the sale transactions: Whenever you feel ready, you can take the necessary steps to sell the assets that you wish to remove from your investment portfolio. Cryptocurrency sellers can complete this step by using a centralized or decentralized exchange.
4. Calculate your capital losses: Harvesting tax losses requires you to do some math. After your asset sales are complete, you’ll need to subtract the sale price for each asset from how much you paid for it, to determine your capital loss. For example—if you originally purchased one bitcoin for $50,000 and later sold it for $40,000, your capital loss for that asset would be $10,000.
5. Use the recorded losses to offset capital gains: Ready for more math? Calculating your capital losses prepares you for this next step, which is subtracting capital losses from capital gains to determine your net investment income. The Internal Revenue Service (IRS) treats short-term and long-term investment income differently, requiring two sets of calculations.
6. Report net capital gains or losses to the IRS: Use Form 8949 and Schedule D of Form 1040 to report your net capital gains or losses for tax purposes. If you’re reporting a net capital loss, then pay attention to the maximum per-year deduction limit imposed by the IRS.
7. Carry forward excess tax losses to future years: Does your net capital loss exceed the IRS’s annual deduction limit? Don’t stress—you can typically carry forward any excess losses to future tax years. Just don’t forget to harvest these additional losses next year at tax time.
Whew! Now that you’re familiar with tax loss harvesting, let’s explore the steps to harvest tax gains. With the exception of the first two steps, notice how the process is similar:
1. Assess your current tax rates: Begin by determining your tax brackets for your short-term and long-term investment income. Short-term capital gains are typically taxed at your ordinary income tax rate, while long-term gains are generally taxed between 0% and 20%.
2. Evaluate your likely tax bracket trajectory: Where do you expect to be in five years? If your income is rising and you’re ascending into higher tax brackets, then it’s logical to expect that your tax rates will increase over time.
3. Review your investment portfolio: Examine your portfolio to identify which of your assets have gained value since the time of purchase—these are all potential candidates for tax gain harvesting.
4. Choose assets to sell: Next, you’ll need to determine which of your profitable holdings, if any, that you want to sell. Just like with harvesting tax losses, your decision to sell an asset should align with your investment objectives and not be motivated strictly by tax savings.
5. Execute the sale transactions: Whenever you're ready—no pressure!—you can perform the steps required to sell the investment assets that you wish to prune from your portfolio. The type of asset that you’re selling generally determines the exchange platforms available to you.
6. Calculate your capital gains: Harvesting tax gains, like recognizing tax losses, also requires you to crunch some numbers. After selling an asset, subtract how much you originally paid for it (the asset’s cost basis) from the sale price to determine your capital gain.
7. Report net capital gains to the IRS: Use IRS Form 8949 and Schedule D of Form 1040 to report and pay taxes on your net capital gains. If you’re harvesting both short-term and long-term capital gains, then you’ll need to report them separately.
Pros and cons—crypto tax loss harvesting
Crypto investors can benefit from harvesting tax losses, but that doesn’t mean that this tax reduction strategy has zero drawbacks. Let’s quickly explore everything to love and hate about crypto tax loss harvesting.
The pros of crypto tax loss harvesting:
- Reduces your taxable income for one or more tax years
- Creates opportunities to rebalance your investment portfolio
- Increases your adaptability as a trader or investor in a volatile crypto market
- Enhances your portfolio’s after-tax return by strategically realizing capital losses to offset capital gains
The disadvantages of crypto tax loss harvesting include:
- May not align with your investing strategy
- Increases your transaction costs such as crypto gas fees
- Creates the risk of mistiming the market and missing a rebound
- May trigger a wash sale if you repurchase a substantially identical asset within 30 days
- Produces annual tax benefits that are capped by the IRS
- Eliminates your exposure to the asset’s long-term growth potential
Pros and cons—crypto tax gain harvesting
Just like harvesting your crypto tax losses, using cryptocurrency tax gains to reduce your overall tax liability is a strategy with both benefits and challenges. Let’s examine the pros and cons of crypto tax gain harvesting, starting with what’s to love:
- May enable you to pay a favorable tax rate on your crypto profits
- Taxpayers in low income brackets can potentially avoid long-term capital gains tax
- Creates opportunities for strategic portfolio rebalancing
- Eliminates your exposure to future tax rate increases
The drawbacks of crypto tax gain harvesting include:
- Establishes an immediate tax liability in the current tax year
- Requires you to predict your tax liability trajectory
- Might not align with your investing strategy
- Creates market timing risks that can be exacerbated by the volatility of crypto
- Boosts your crypto gas fees and other transaction costs
- Reduces the potential for compound growth in your crypto portfolio over time
When should you harvest tax losses or tax gains?
Deciding whether to harvest crypto tax losses, harvest crypto tax gains, or not harvest anything at all may not be a straightforward decision. Tax loss and tax gain harvesting are both complex tax optimization strategies that require considering a diverse range of factors including, for tax gain harvesting, your expected future tax rates.
To evaluate whether crypto tax loss or tax gain harvesting may be right for you, ask yourself these key questions:
1. Which crypto assets in my portfolio have gained value? Which assets have values that are reduced? Your candidates for tax loss harvesting are limited to the holdings in your portfolio that are currently worth less than what they cost, while you can only harvest tax gains from assets that have increased in price.
2. What is my current tax rate? Do I expect that tax rate to increase or decrease in the future? Tax loss harvesting may be suitable if you're currently in a high tax bracket because realizing tax losses now enables you to offset a higher amount of taxable income. Tax gain harvesting may be ideal if you're currently in a low tax bracket but anticipate moving to a higher bracket in future years.
3. What is my expected tax liability this year? If you’re carrying forward capital losses from a previous year, which lowers your tax bill, then you may feel comfortable with recognizing some capital gains. But if you already expect to owe a hefty amount at tax time, then harvesting tax losses to offset or eliminate capital gains may be the better option.
4. How can my portfolio benefit from rebalancing? You can harvest tax gains or tax losses, or both, to rebalance your investment portfolio in a way that better aligns with your investing strategy. Whether harvesting losses or gains is more appropriate depends on the changes that you wish to make to your portfolio.
5. What are my long-term investment objectives? Both tax loss and tax gain harvesting may support the execution of your portfolio’s long-term investment strategy. Asking this question is important because any decision to recognize capital losses or capital gains should align closely with your investment goals.
How to learn more about tax loss and tax gain harvesting
Want to deepen your knowledge of harvesting tax losses and tax gains, especially in the context of digital assets? Before using either of these advanced tax minimization strategies, leverage these resources to keep learning:
- Personal finance blogs and websites
- Online tax and finance courses
- Cryptocurrency and tax podcasts
- Crypto and tax newsletters
- Digital forums focused on taxes for digital assets
- Webinars and tutorials from tax software providers, including crypto tax specialists
- Crypto tax professionals who provide personal consultations
Traders and investors can also enhance their practical experience with harvesting tax losses and tax gains, with zero financial risk, by using a portfolio simulator. Practicing in a risk-free environment is a smart move—because nobody wants tax problems with Uncle Sam. By exploring the nuanced differences between tax loss and tax gain harvesting, you’re already on the right path to prudently using either of these tax reduction strategies.
