What is Crypto Tax-Loss Harvesting?
Tax-loss harvesting is a strategy that investors utilize in order to offset capital gains taxes by selling positions at a deficit. It is important to note that governments across various nations have added cryptocurrencies to the taxation bracket. On this account, investors have to submit a portion of profits earned from trading digital currencies to the designated taxation authority.
There are various types of taxes applicable to digital assets such as capital gains and sales taxes etc. At the same time, the ratio of cryptocurrency taxation depends on various regulations such as short-term trading or long-term investing.
How does Crypto Tax-Loss Harvesting Work?
Cryptocurrency investors can lose a considerable portion of their investment gains on account of tax obligations. However, tax-loss harvesting is a strategy that is a legal workaround to prevent massive tax-cuts.
The most traditional method of tax-loss harvesting is to identify a cryptocurrency that has lost a considerable amount of value since its purchase. The next step is to sell the identified currency at a loss in order to offset overall tax liabilities. Here are some steps employed for tax-loss harvesting:
Determine Capital Loss
The first step is to measure the difference between buying and current price of the tax-offset cryptocurrency. In this manner, investors can determine the ratio of their capital loss.
Offset Capital Gains
The next step is to use the capital loss transaction to offset capital gains tax applications generated from selling other digital currencies. It is going to reduce the overall taxation liability for an investor.
The taxation amount is affected by the timing of the trade and the market conditions. Therefore, investors can choose to offset capital gains from the same tax year or continue forward to the next year.
Maintain detailed records of all capital-loss transactions to maintain an updated tax-loss harvesting strategy. These records will allow the investors to work with authorities and provide transaction details.
Risks Associated with Crypto Tax-Loss Harvesting
Tax-loss harvesting is a helpful strategy that assists investors in reducing tax deductions. However, there are various risks associated with implementing this method.
Wash sales generate illegal profits by continuously selling and purchasing the same type of financial instruments within short durations. Taxation authorities implement regulations to prevent wash-sales to limit the ability of cryptocurrency investors to implement tax-loss harvesting and may expose them to trouble with regulators.
Short and Long-Term Gains
Traditionally, short-term capital gains have higher tax obligations while long-term capital gains have smaller tax obligations. Using tax-loss harvesting method and buy back sold digital currencies after the 30-day duration, can lead to short-term and higher tax deductions regardless of the long-term storing of the asset.
Cryptocurrency prices are subject to frequent volatility and connected to variable factors such as economic, technical, trading volume, and updates etc. Therefore, in case an individual sells a cryptocurrency just before it hits new ATH it can be a bigger loss in comparison to the tax-loss harvesting offset.
Crypto taxation laws are complex and require time and skill to understand. At the same time, regulatory framework around cryptocurrencies is still evolving. Therefore, it can troublesome for the average investor to measure the finer intricacies of taxation law since a considerable portion of legal trial is open to subjective interpretations.
Considering the innovative use cases and unique trading culture of cryptocurrencies investors may need to account for legal consultation fees when using tax-deduction techniques such as tax-loss harvesting.
Lack of Knowledge
Investors with limited knowledge regarding the cryptocurrency market and specific taxation regulations within their local jurisdiction may have to deal with financial penalties or other consequences.
Tax-loss harvesting is not the only method to reduce or save taxation obligations. It is necessary that cryptocurrency investors take into account various important factors such as legal viability, local taxation laws, and guidelines issued by designated taxation agencies before employing the tax-loss harvesting method.