Crypto tax-loss harvesting: Benefits and strategies

Taxes on crypto gains can sometimes take the shine off profitable trades, but there are ways to help manage those costs. One strategy many traders use to reduce their tax liability and enhance returns is crypto tax-loss harvesting. 

In this guide, we’ll explain tax-loss harvesting, when it makes sense to use it, and how you can make the most of this popular trading strategy.

What is tax-loss harvesting?

Tax-loss harvesting allows investors to reduce their tax liabilities by offsetting gains with losses, and it's effective for both traditional securities and cryptocurrency investments. It can lower tax bills or serve as a hedge against market downturns, but it requires careful planning and knowhow. 

To use tax-loss harvesting, traders sell crypto assets that have decreased in value since purchase to realize a loss, which can offset gains from other investments and lower their overall tax bill. Here are the main steps to apply this strategy:

• Open a taxable investment account: Set up a taxable investment account that allows you to invest in crypto with after-tax dollars. This account type provides the flexibility needed to capture tax-loss harvesting opportunities.
• Invest in assets based on your investment horizon and risk tolerance: To harvest tax losses, you’ll need investments that have declined in value relative to their purchase price. Although your goal is long-term profitability, market fluctuations may lead to some assets decreasing in value, enabling potential loss harvesting.
• Sell assets at a loss: Realize losses by selling or disposing of crypto assets that have dropped in value. These losses can offset gains made in the same tax year or reduce overall taxable income.

When do traders harvest crypto losses?

The annual deadline for tax-loss harvesting is generally December 31, but traders should manage their crypto tax reporting throughout the year, not just at the end. While many wait until the last minute to think about tax-loss harvesting, capital losses can be harvested at any time. Given the cryptocurrency market's volatility, investors can strategically sell assets at a loss during price dips to offset gains and reduce their taxable income.

To maximize tax-loss harvesting opportunities, traders need to identify which tokens have the highest cost basis relative to their current prices. The cost basis is the original value of an asset when it was acquired, and it’s used to calculate the gain or loss upon sale. For example, a trader might have bought Bitcoin (BTC) or Ethereum (ETH) multiple times at different prices. Selling the coins with the highest cost basis maximizes realized losses (and minimizes gains for gain positions). By keeping detailed records of these transactions, traders can determine which tokens are best to sell for a tax-deductible loss.

When to sell crypto for tax-loss harvesting

Savvy investors often use market downturns to sell assets at a loss. To do this effectively, they must track all their transactions carefully. Monitoring both realized and unrealized gains and losses helps traders identify the best times and assets to sell. 

Realized gains or losses occur when an asset is sold, while unrealized gains or losses are the changes in value for assets still held. By understanding these dynamics, traders can make informed decisions throughout the tax year to minimize their liabilities.

What are the benefits and limitations of crypto tax-loss harvesting?

While crypto tax-loss harvesting’s primary advantage is the potential reduction in capital gains taxes owed to the Internal Revenue Service, traders can also offset up to $3,000 of personal income with crypto losses each year if capital losses exceed capital gains. They can carry any unused losses forward to offset future gains in subsequent years, providing a long-term tax benefit.

However, there are limitations and risks associated with tax-loss harvesting. Frequent buying and selling of assets can lead to significant transaction fees, which may reduce the overall benefits. It’s important also to be aware of the "wash sale" rule, which prevents traders from claiming a loss on the sale of a security if they repurchase the same or a substantially identical asset within 30 days before or after the sale. 

When is crypto tax-loss harvesting applicable?

Tax-loss harvesting can be useful for crypto traders aiming to manage tax liabilities and grow their portfolios. However, its effectiveness depends on several factors, such as income levels and investment duration. Successful tax-loss harvesting requires careful planning, thorough record-keeping, and strategic decision-making to maximize benefits.

Here's a look at key considerations for implementing a tax-loss harvesting strategy:

Income considerations 

Tax-loss harvesting benefits high-income individuals the most. Those in lower tax brackets may not gain as much advantage, as they might not owe taxes on capital gains depending on their income level.

Planning ahead

Preparation is key for effective tax-loss harvesting. While traders can implement it anytime during the year, many tax professionals recommend a consistent tax planning approach. This involves regularly reviewing year-to-date taxable income, including capital gains, projecting expected income for the remainder of the year, and assessing asset positions with unrealized losses that could reduce taxable income before year-end. For efficient planning, maintain thorough records of all transactions to ensure accuracy and track opportunities for potential loss harvesting.

Effectiveness across investments

Tax-loss harvesting is especially effective for individual stocks, actively managed funds, and ETFs. In traditional markets, some securities offer easier opportunities for harvesting losses than others. Index fund investors, for example, might find it challenging to use this strategy. Consulting a tax professional can help identify which parts of a portfolio can benefit the most.

Investment duration matters

The duration for which an asset is held impacts the tax rate on gains. The IRS classifies assets, including crypto, as short-term or long-term investments depending on your holding period. Long-term capital gains rates apply to assets held for more than a year, while short-term rates apply to those sold within a year of purchase.

Mindful selling

Don’t sell underperforming assets solely for tax benefits. An asset’s current downturn doesn’t guarantee it will stay down. Many traders buy crypto for its long-term growth potential. If a crypto project's fundamentals remain strong, holding the asset may be more beneficial than realizing a loss. Conversely, a crypto’s fundamentals may have worsened, indicating it may be time to ditch the project.

Reinvestment opportunities

Beyond tax savings, tax-loss harvesting can create the possibility for reinvestment. Many traders use their tax savings to buy more cryptocurrency, leveraging the compounding effect to grow their portfolios and increase overall wealth.

Optimize your crypto tax strategy with CoinTracker

Strategies like crypto tax-loss harvesting can effectively minimize tax liabilities, but they require traders to meticulously record transaction details, including purchase and sale dates and times. Fortunately, CoinTracker streamlines the process. 

With support for 500+ exchanges and wallets, 10,000+ cryptocurrencies, and 20,000+ DeFi smart contracts, CoinTracker captures every crypto transaction. Simply connect your accounts and let us handle the rest.

Start for free and discover why over 2 million traders trust CoinTracker for their crypto tax-reporting needs.

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