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Are Cryptocurrencies Subject to Tax and Wash Sale Rules?

As the end of the year approaches, taxpayers look at their portfolio of investments and attempt to understand the applicable tax rules. One of the most researched topics is taxation of cryptocurrencies — virtual currencies that act a medium of exchange and can either increase or decrease in value. Cryptocurrencies are generally decentralized which means that they can function without the need of a central authority or banks.

The proper income tax treatment of cryptocurrencies can be complicated. The IRS is of the view that cryptocurrencies fall in the category of “property” and not currency for US federal income tax purposes. Therefore, taxpayers can have a taxable event by selling, earning, or spending cryptocurrencies.

Do wash sale rules apply to Cryptocurrencies?

Wash sale rules were introduced to discourage taxpayers from “tax loss harvesting.” The IRS instituted wash sale rules to prohibit taxpayers from reducing tax liability by selling an investment (a stock or a security) at a loss and then buying the same or “substantially identical” investment within 30 days before or after the sale. In the absence of wash sale rules, taxpayers would have been able to reduce tax liability by recognizing the loss at the end of the year, while maintaining their position by buying it back within 30 days before or after the sale. Hence, wash sale rules were introduced to disallow such tax losses.

As of this publication date, it is believed that the wash sale rules do not apply to buying and selling of cryptocurrencies. The reason being that cryptocurrencies are not considered stock or securities for US federal income tax purposes. Therefore, taxpayers looking to “harvest tax loss” find more flexibility in trade of cryptocurrencies than they do in trade of stocks or securities.

Though wash sale rules do not seem to apply to cryptocurrencies, taxpayers should keep in mind that the IRS could still disallow a loss if the transaction fails to result in a “bona fide” loss or lacks economic substance. Taxpayers are discouraged from entering transactions for the mere purpose of recognizing a loss for the sake of reducing tax liability while maintaining position in the same security by buying it back within the 61-day period.

Are cryptocurrency theft losses tax deductible?

In some instances, taxpayers may find themselves in a position where a tax loss is triggered by theft of cryptocurrency. As of the writing of this article, if a loss has occurred due to theft in connection with a trade entered for profit, it is believed that the loss is deductible as ordinary loss and can be used to offset ordinary income.

Article by Muhammad Junaid, Senior Tax Manager

Matthew John McNally
Matthew is an enrolled agent with two decades of tax planning, compliance, and advisory experience, much of it at Big Four accounting firms, where he guided clients with wide-reaching financial concerns.