How Did We Get Here
It’s been about ten years since people started buying cryptocurrency. In the beginning, you had to go on strange exchanges like Mt. Gox that required a lot of hoops to jump through to purchase bitcoin at $1.
Now it’s so much easier to partake in crypto, where 55% of people surveyed who owned bitcoin in 2021 said it was the first year they participated. How people will use cryptocurrency is still unclear but should generally fall into the categories of transactions, storing value, NFTs, and smart contracts. And cryptocurrency technology is moving so fast that many governments are taking a long time to regulate it.
Old Way vs. New Way
At the beginning of October, I attended a webinar about cryptocurrency and how financial planners should start thinking about it. The biggest thing I got about crypto is that it uses authentication to facilitate transactions versus our standardized financial system of trust.
The primary financial industry requires a lot of intermediaries to facilitate transactions, and for each transaction, a fee is tacked on. We have to trust these institutions that they will do the right thing, and we have regulator agencies that are supposed to check these institutions to ensure they are doing the right things. It’s a very centralized system that has created a lot of efficiencies but is prone to fraud issues because these intermediaries have all the information, and buyers and sellers don’t.
Crypto uses authentication to facilitate transactions by using the blockchain ledger to record those transactions. Then computers on the network authenticate those transactions to ensure everything lines up. This prevents double spending on a digital coin. Theoretically, a bank could keep two accounting books and lend out money that is not supposed to be lent out because it was already spent somewhere else. Since this system is based on trust, we need to have other organizations check to see if people are doing the right thing.
Since the authentication has to be done on many different networks, this can cause a transaction not to go as fast as picking a central location to facilitate the transaction. And within cryptocurrency, some coins choose to be more centralized to help with efficiencies. Some want to stick with decentralization, which takes longer to process transactions but maintains a purer sense of authentication.
There are a lot of smart people trying solve all these issues, so we’ll see what solution the majority end up on in the future.
The Tax Loophole That Will Probably Close in 2022
The SEC is in charge of regulating securities, but cryptocurrencies are not securities yet. This could change in the future if Congress decides to place cryptocurrencies into this field. And it looks like they will at some point with the new Build Back Better legislation. In the current version passed by the House, they want to close a tax loophole on cryptocurrencies that allowed people to claim losses on dips in the price of cryptocurrencies which creates a tax deduction. Then participate in the gain on the price that can’t be done with regular securities like stocks.
For example, if a stock goes down from $100 to $70, and someone has 1000 shares, this creates a $3000 loss unrealized loss. Suppose that investors believed that the price drop was temporary, like what investors saw in March of 2020 when covid-19 disrupted the markets before the Federal Reserve stepped in with monetary policy and Congress with Fiscal policy to keep the security markets afloat. An investor could have predicted that the market would recover and sell their shares at the bottom to realize the loss, which would lower their taxable income by $3000.
The investor would have to wait 30 days to buy back the same or similar securities to keep that loss for tax purposes. The investor could have chosen to invest in another area and be fine, but if they wanted to invest in the same stock or industry, they would probably be facing the wash rule and wouldn’t get that tax reduction.
This wash rule only applies to securities, so investors could have sold their cryptocurrencies at the dip for the past ten years to get the tax deduction. They could have bought their cryptocurrency the same day with a substantial economic motive and benefited from a rally. This would also reset their cost basis to a lower amount and, with the right strategy, get more long-term gains on their asset. But in 2022, the wash rule will probably apply to Cryptocurrencies once Build Back Better is passed by the Senate and signed by President Biden.
How Someone Could Use The Tax Loophole
In December, many cryptocurrencies took a hit. If someone has any cryptocurrency positions in the red, they might want to take advantage of the Wash Rule by harvesting the losses. This might not be easy because some exchanges don’t allow picking the cost basis method. They only enable First In, First Out for reporting cost basis, which means that the first coin bought is the first one to be sold. FIFO is not a good strategy for tax-loss harvesting since the first coin someone purchased could have unrealized gains.
So what needs to happen is that someone needs to pick the positions that are unrealized losses if they want to take advantage of the wash rule. So it is best to check with your exchange to see what is possible. It might even make sense to switch to a different exchange to perform this tactic.
If the gains from tax-loss harvesting are more significant than the effort, it makes sense to participate in this strategy. Suppose someone has $10,000 of losses and is in the 24% tax bracket and 9% state tax bracket. This person could claim $3,000 in loss this year and save themselves $1,020 in taxes in about 30-90 minutes’ worth of work if they know what they are doing and keeps a good set of records and documentation.
If the money to be saved is $10, it is not an excellent strategy to follow. Make sure the juice is worth the squeeze. The rest of $7,000 in losses can be carried forward to the following years until they are used or offset by other gains, which could result in additional tax savings of as much as $2,380, or $3,400 in total.
Know The Deal, Before You Accept The Deal
The future will change how we interact with our environment, but it will also use some past rules to determine that interaction. With the wash rule being applied to cryptocurrencies, look for more adoption by governments and the general public in the crypto space. So it would be wise to understand supply and demand, how wallets work, taxes, and other things related to this space.
And if you understand the field, the domain, and the skills required to take advantage of any future opportunities, you will be more prepared for them. So continue to be a life-long learner, so you have fewer “wondered-what happened” moments and more “I made it happen” ones.
*I’m not an expert on everything about cryptocurrencies, and I’m not a tax preparer. This is general information, and people should do more research on their own or seek out a professional to help them in this space since other considerations need to be made if utilizing this strategy.*
*Links to other sites are for educational purposes and not endorsements*
