Cryptocurrency May Soon Be Subject To Wash Sale Rules

The highly controversial Infrastructure bill is being looked at by the Ways and Means Committee. The Committee of Ways and Means is the chief tax-writing committee of the United States House of Representatives. The Committee has jurisdiction over all taxation, tariffs, and other revenue-raising measures and a number of other revenue-generating programs.

Ways and Means summary report published on September 13, 2021 talks about subjecting cryptocurrency to the wash sale rule. Cryptocurrencies are not subject to the wash sale rule at the moment. This loophole has allowed crypto holders to generate tax losses (without economically realizing a loss) and artificially reduce the tax bill.  

What is a Wash sale?

According to the 1091 of the IRS code, a wash sale occurs when an individual sells a stock or security at a loss and, within 30 days before or after this sale, buys a “substantially identical” stock or security, or acquires a contract or option to do so.

The current language only subjects “stocks & securities” to the wash sale rule. Since cryptocurrencies are treated as property per IRS Notice 2014-21, they are not subject to the wash sale rule.

Let’s see how the wash sale rule works with stocks and cryptocurrencies next.

Assume Jennet buys a share of Company A stock for $2,000 on January 10, 2021. On January 15, 2021, Company A stock is trading at a much lower price of $1,200 per share. If Jennet were to sell her position and buy another share at $1,200, she would NOT be able to claim the capital loss of $800 ($2,000 – $1,200) due to the wash sale rule. Therefore, $800 loss is disallowed under wash sale rule.

Substitute Company A stock with bitcoin (BTC) or any other cryptocurrency. Here, Jennet would be able to claim the $800 loss as a capital loss because cryptocurrencies are not subject to the wash sale rule.

This loophole allows crypto holders to trade cryptocurrencies which act just like stocks, but under the tax treatment of property and generate losses more aggressively by skipping the 30-day period.

Implications of the Ways and Means Summary

Sec. 138153 of the Ways & Means summary document plans to subject digital assets to wash sale rule.

“This section (Sec. 138153) includes commodities, currencies, and digital assets in the wash sale rule, an anti abuse rule previously applicable to stock and other securities. The wash sale rule in section 1091 prevents taxpayers from claiming tax losses while retaining an interest in the loss asset”

The Ways & Means Committees reasoning behind the proposal is clear. Cryptocurrencies did not exist when the congress enacted 1091. So, it doesnt have any reference to digital assets. Therefore, cryptocurrency holders have no legal requirement to apply this provision although cryptocurrencies work very similar to stocks & securities. Closing this loophole would generate the additional tax revenue needed to fund the massive Infrastructure bill.

Closing this loophole doesn’t mean that crypto taxpayers are completely missing out from the tax benefits related to wash sale losses. The wash sale rule doesn’t allow you to deduct losses on transactions that are considered wash sales. Instead, it allows you to add disallowed losses to the cost basis of the coin. Since you increase the cost basis, you would realize less taxable gains when you later sell the coin for a profit. Thus, crypto users will only experience a deferral of a tax deduction, not a complete elimination of a tax deduction.  

Assume Jennet’s BTC transaction in the above example is a wash sale. In that case, Jennet wouldn’t be able to deduct the $800 capital loss on her taxes. Instead, she would increase the cost basis of her newly purchased BTC to $2,000 ($1,200 + $800).

Say she later sells this coin for $10,000. In this case, she would report a $8,000 ($10,000 – $2,000) gain while accounting for the $800 loss disallowed under the wash sale rule. (If she doesn’t Increase the cost basis by the disallowed wash sale loss, she would incorrectly incur a higher capital gain of $8,800 ($10,000 – $1,200).

Unfortunately, the burden of tracking wash sales and adjusting basis accordingly will fall on cryptocurrency exchanges which will be subject to 1099-B reporting under the Infrastructure bill. Taxpayers will also have a responsibility to track wash sales occurring across multiple exchanges and wallets.

Timing

If the Ways & Means Committee suggestions are adapted, cryptocurrency trades occurring after December 31, 2021, will be subject to the wash sale rule.  

Forbes Crypto & Tax Webcast: Get in-depth coverage and insights on how to navigate the crypto tax landscape on September 21 at 2:30 p.m. (EST). Register here.

Disclaimer: this post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.