TaxWatch: Cryptocurrency investor losses are being turned into IRS gains — here’s how they’re doing it

by | Dec 7, 2022 | Stock Market

The Internal Revenue Service has been turning up its scrutiny on cryptocurrency investors in recent years, and as that happens, more investors have been turning to the tax code’s rules on investment losses. That’s according to a study released this week that shines a light on the link between IRS enforcement and “tax-loss harvesting.”

The latter is a tax planning strategy many crypto investors will have to consider after 2022’s tumble for bitcoin, ethereum and other digital assets — not to mention the implosion of the cryptocurrency exchange FTX. Within the past decade, the IRS and other tax agencies around the world have been increasingly focused on ensuring crypto investors fully report and pay taxes on their gains. The IRS has previously sent cautionary letters to crypto traders and sued cryptocurrency exchanges in its compliance campaigns. More cryptocurrency investors are paying attention, according to the study released on Monday. Researchers at SC Johnson College of Business at Cornell University, Cornell’s Fintech Initiative and the University of North Carolina’s Kenan-Flager Business School poured though a range of information, including anonymized data about 500 large retail cryptocurrency traders. Roughly one-fourth were U.S.-based taxpayers.

“Compared to international peers, domestic traders increased ‘tax-loss harvesting’ by approximately 8%, on average, following an increase in tax scrutiny by the Internal Revenue Service.”

Compared to international peers, domestic traders increased tax-loss harvesting “by approximately 8%, on average, following the increase in tax scrutiny,” the researchers said. “Domestic traders sell more losing positions than international peers at the end of the year,” they later added. The same pattern of increased tax-loss harvesting played out when researchers looked at billions of trades from more than 30 cryptocurrency exchanges. Of course, tax-loss harvesting is a long-established planning strategy when it comes to stocks, bonds and other conventional investments. It typically comes into focus at the end of a year — especially for a bruising year like 2022. In a nutshell, taxpayers gather their investment losses and use the losses to offset capital gains and/or carry forward the losses so they can be applied to future gains.Researchers are focusing on crypto tax-lost harvesting because they see it as a gauge of overall tax reporting. “A crypto investor’s decision to make use of tax-loss harvesting as a tax planning strategy by necessity implies a degree of tax compliance, in that the investor must report crypto trading to the tax authority to take advantage of the strategy,” researchers wrote.

“When investors with traditional assets like stocks sell at a loss, the IRS ‘wash sale’ rule cancels a capital loss if the person buys a ‘substantially identical’ investment 30 days before or after the sale. ”

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