You have to be living under a rock to have missed the news about crypto winter. The digital asset market, which includes both crypto (or virtual) currency and non-fungible tokens (NFTs), that was on fire at the end of 2021 crashed earlier this year and is showing no real signs of recovery. Nature, even in the metaverse, abhors a vacuum. In the absence of hype-driven investing encouragement digital asset trading platforms began suggesting harvesting losses at the end of 2022 to reap tax advantages come tax season (now). Although many such articles and blog posts were good about noting (in the fine print) that “results may vary, consult your tax professional” the overall message was that loss harvesting now would reap tax savings in a few months. Unfortunately, taxpayers who didn’t read or didn’t understand the fine print may be in for a nasty surprise.
Tax-loss-harvesting “marketplaces” have cropped up to offer a place for investors to offload their now largely valueless NFTs. But what, you may be asking, would these marketplaces gain by buying up valueless digital “property”? Transaction fees. The investor must pay fees to the marketplace to sell their NFTs. Often the fees are more than what is being paid for the NFT(s) being sold. The seller still thinks this is an opportunity because, after tax savings, it won’t be such a big loss.
The IRS doesn’t offer much guidance concerning the taxability of digital assets. What it does offer (mostly Notice 2014-21) makes it clear that digital assets are to be treated like property. The property they most closely resemble for tax purposes is stocks. Their sale is reported on Form 8949 and Schedule D, “Capital Gains/Losses.” Why is this important? Because in most cases losses from the sale of capital assets can only be used to offset capital gains income. Or, to put it another way, passive (investing) losses can only be used to offset passive (investing) income. These losses cannot be used to offset ordinary income (from, for example, wages or self-employment).
What does this mean? It means that unless the taxpayer has passive income against which to apply the harvested losses, the losses will be largely unusable in the current tax year. For example, let’s say a taxpayer managed to find a stock that went up in 2022 and sold it for a $20,000 gain. That same taxpayer harvested $50,000 in digital asset losses. The losses can completely offset the capital gain on the stock sale. Additionally, the taxpayer can take another $3,000 of capital losses. The remaining $27,000 in losses carry forward indefinitely (as the rules stand right now) to offset future capital gains. If the taxpayer has no capital gains in the future, they can continue to take $3,000 in losses per year until the carryforward is gone. If, on the other hand, the taxpayer had no capital gains but only the $50,000 loss, they can take $3,000 in capital loss and they now have a $47,000 carryforward. Assuming this investor has no other investments with which to realize a capital gain, that loss is going to be used $3,000 per year for the next sixteen years. In a word, yuk.
The one bright spot? The wash sale rules. Although the limited amount of IRS guidance surrounding digital assets treats them as property (similar to stocks), digital assets are not stocks and, as of right now, the wash sale rules don’t apply. That means that taxpayers who sold their cryptocurrency at a loss can buy back the same type of coins (so BTC
BTC
ETH
Wash sale rules notwithstanding, what all of this means in the big picture is that taxpayers who harvested large losses may be expecting large refunds because they think that the losses can be used to offset their wages or self-employment earnings and that is not the case. Omri Marian, a law professor at UC Irvine, thinks that once they find out they cannot fully use their harvested losses, some taxpayers may consider taking the position that they are NFT or cryptocurrency “traders.” That position means that they are “in the business of” trading digital assets. For most investors this is an exceptionally aggressive position that is unlikely to stand up under an IRS examination (audit).
NFT marketplaces may be the worst offenders with respect to promoting the advantages of loss harvesting but cryptocurrency trading platforms are also promoting it as the silver lining behind crypto winter’s seemingly ever present storm clouds. It’s important to remember that loss harvesting may or may not benefit the trader (the taxpayer) but it always benefits the platform (because of the fees). Marian says “The bottom line is that, as always, be very careful when someone sells you a tax benefit. If it seems too good to be true, it’s probably because it is.”