The cryptocurrency trading scene can be volatile. The past few years have shown this fact, and investors are leveraging this unpredictability to make massive profits. Of course, this also means that cryptocurrency investments are prone to losses. Understanding these losses can actually provide a few benefits, such as how to use the deficits to potentially lower your tax liability.
Claiming your crypto losses properly allows you to offset your gains. Whether you’re a total novice or a seasoned crypto trader, knowing how this process works gives you various advantages as you plan and execute your tax strategy.
Below, QuoteColo has shared an informative blog post discussing crypto losses and how you can use them to your advantage when it comes to taxes. Keep reading!
Understanding Capital Gains and Losses in Crypto Trading
The IRS treats cryptocurrency as property. Property, in this sense, is a capital asset. Any earnings that you gain from selling and trading capital assets creates a taxable event. In other words, you will need to pay capital gains taxes. The rates depend on your bracket, with the highest ones having to pay 20% of their capital gains.
The reverse of a gain is a capital loss. This happens when the sale price is lower than the basis, which is the original amount of your cryptocurrency purchase. If the currency’s value decreases and you sell at a loss, you will incur a capital loss.
Realized vs. Unrealized Losses
Capital losses can be categorized into two types: realized and unrealized losses. A realized loss occurs when you sell or trade your crypto assets at a price lower than what you paid for it. An unrealized loss is when your crypto’s value drops, but you haven’t sold it yet. Only realized losses can be reported on your tax forms since unrealized gains haven’t triggered a taxable event yet. So, even if your portfolio is down, if you haven’t sold your assets, those losses don’t count for tax purposes.
Can You Use Capital Losses to Offset Your Gains?
This is the crux of the matter: can cryptocurrency investors use their losses to reduce their capital gains and, by extension, their taxable income? Yes. One of the key benefits of reporting your crypto losses is the ability to use them to offset your gains. Given how the IRS recognizes your crypto investments as property, these fall under the IRS Section 1221. This means that you can include the deficits in your tax filing as losses and use them to offset both short-term and long-term capital gains.
Short-Term vs. Long-Term Capital Gains and Losses
What are short-term and long-term capital gains anyway? These two categories have distinctions that lead the IRS to tax them differently. Gains from the cryptocurrency sale or trade can be classified under short- or long-term capital gains and losses, but not both. Here’s why.
Short-term Capital Gains and Losses
Short-term capital gains are the profit you make after selling a cryptocurrency you held for less than a year. These gains follow ordinary income tax rates, which can range from 10% to 37%, depending on your tax bracket. On the other hand, short-term capital losses are the losses you incur after selling an asset you’ve held for less than a year. You can use these losses to offset your short-term capital gain tax liability.
Example Scenario: You purchased Bitcoin in December 2023 and sold it at a loss in August 2024. The loss will be classified as short-term since you’ve held it for only a few months. You can then apply this loss to your ordinary income up to $3,000 in a single tax year. The rest of your loss will be carried over to the next tax year.
Long-term Capital Gains and Losses
Long-term capital gains and losses are the profits and losses you make after selling an asset you’ve held for over a year. Long-term capital gains have lower tax rates than the shorter ones, with 20% as the maximum rate. Why is there a difference? The government wants to encourage investors to hold assets for longer to stabilize the market and reduce volatility.
Cryptocurrency is volatile in nature, though, so why are these capital assets considered property instead of securities? There are a few reasons, such as the decentralized nature of cryptocurrency and the lack of investment contracts. Plus, cryptocurrency has a functional utility that makes it distinct from securities — the former can be used as a medium of exchange and not merely as a speculative investment.
Example Scenario: Let’s say that the Bitcoin you sold at a loss in August 2024 was purchased in June 2023. Because you held the asset for more than a year, this would be classified as a long-term capital loss. You can then use this loss to offset long-term capital gains when filing your tax return. This tax strategy can be particularly useful for investors with significant crypto holdings, given how the IRS taxes long-term gains much more favorably than short-term ones.
The Wash Sale Rule and Crypto: What You Need to Know
The Wash Sale Rule is a strict regulation set by the IRS to prevent investors from claiming tax deductions on securities they sold at a loss only to be repurchased within 30 days. This practice allows investors to claim their losses without actually selling the underlying asset. The Wash Sale Rule stops this practice but only applies to securities.
Cryptocurrency is considered property, not a security. As such, crypto investors are not beholden to the Wash Sale Rule. You can sell your asset at a loss, claim the deduction, and then repurchase the same cryptocurrency right away without any violations. We do recommend proceeding with caution with this practice. For one, the volatility of the market may affect the value of the asset you just sold. Plus, the new regulations may bridge this gap in the future.
How To Claim Crypto Losses Taxes
Here’s a definitive guide you can follow to leverage losses against your tax liability.
- Track Your Transactions – Keep detailed records of your crypto trades, including dates, purchase prices (cost basis), and sale prices. You’ll also want to differentiate between the long-term and short-term investments.
- Calculate Your Gains and Losses – You’ve made a loss if your sales price is lower than the basis. If it’s the reverse, you made a profit.
- Report on IRS Form 8949 -Once you’ve grouped your short and long-term capital gains and losses, report them on Form 8949. List the details such as the description, acquisition, and disposition dates, cost basis, and the sales price.
- Transfer Totals to Schedule D -Transfer the totals from Form 8949 to Schedule D of your tax return. This is where gains and losses are calculated.
- Apply Losses -If you incurred losses, use them to offset your gains and potentially lower your taxable income by up to $3,000.
Common Pitfalls to Avoid
Accuracy is critical when using losses to reduce your capital gains. Any errors you make may result in penalties that prevent you from enjoying the potential tax reduction. Here are some common ones.
- Not keeping detailed records: Always make sure that you have accurate records of every purchase, price, and proceeds for all your transactions.
- Underreporting or omitting transactions: Be thorough and honest in your reporting to avoid issues with the IRS. The agency may put you under scrutiny if they detect inconsistencies or missing information.
- Misclassifying short-term vs. long-term losses: If you don’t classify long-term gains and losses correctly, you could possibly lose hundreds, if not thousands, of dollars in tax savings, given the higher rates for short-term investments.
Wrapping Up: Offsetting Capital Gains With Crypto Losses
As a capital asset, your cryptocurrency investments can realize gains or losses upon sale or trade. As such, it’s important to keep track of these values so that you can leverage the latter to offset your tax liability. It’s also critical to stay updated with changing legislation about the tax treatment of cryptocurrency. While the Wash Sale Rule doesn’t apply to these assets yet, this may change in the future. If you’re unsure, we recommend working with a tax professional who can provide guidance for tax filing and management.
QuoteColo is here to help. Schedule investment consultations for Bitcoin and cryptocurrency mining. Contact us today to learn more.