How do I avoid paying tax on a cryptocurrency gain that I have already lost?

Question

I'm not sure if this question belongs here, but I'm super confused about how cryptocurrencies get taxed.

I invested $10,000 at the end of 2020. I made about 30 or so short-term trades in 2021 and sold everything in May. I made $40,000. I re-bought a single cryptocurrency with $50,000 (initial investment + gains) blindly and my total value is now $12,000 since the whole crypto market has been bearish.

Assuming I don't sell it until the end of 2021 and the price does not go up, do I pay tax on $50,000 since it was a profit? If so, what would be my best option to minimize tax on it? I can't cover 25% tax on $50,000 even if I sell everything.

Can I avoid tax on $50,000 if I sell my current position for $12,000?

I live in the U.S.

Answer 1

In the U.S., gains from cryptocurrency trading are taxed just like trading stocks: as capital gains.

Capital gains are only taxed when they are realized. At this time, you have realized a $40,000 gain, but you have not realized a loss. If you do not sell your new position before the end of the year, you will be taxed on the $40,000 gain. (Note: your gain is $40,000, not $50,000, because you had a cost basis of $10,000 on your investment, so your gain is $50k - $10k.) Because you only held the asset for less than a year, this is a short-term gain, which means it is taxed at your regular income tax rate. (If you had waited at least a year before you sold, any gain would be a long-term gain and taxed at a lower rate.)

If you were to sell your position today for $12,000, the second trade would have a capital loss of $38,000 ($50k - $12k). When you do your 2021 taxes, assuming you have no other investment gains/losses, you would be taxed on a net gain of $2,000 ($40k - $38k).

A note about the wash sale rule:

If we were talking about securities, you cannot sell your position now and then immediately buy back in and still take that capital loss on your taxes, due to the wash sale rule. If you sell at a loss and wish to claim that loss on your taxes, you must wait a minimum of 30 days before you buy back in.

However, according to CPA Jeffery Levine, the wash sale rule does not apply to cryptocurrency transactions. That means if you want to continue to hold your position, you could sell now at a loss, buy back in shortly thereafter, and still take that loss on your 2021 taxes.

Answer 2

Since all the sales are in the same tax year, you're fine

Crypto-"currencies" don't tax like recognized currencies, just regular securities like stocks.

Capital gains are taxable when you sell the stock/security.

Likewise, capital losses are only created when you sell.

So if you sell this year, your gains and your losses happen inside the same tax year.

Capital gains and losses cancel-out and reconcile within the same tax year.

They will cancel each other out right on the Schedule D (actually right on the Form 8949, which is a tally sheet for Schedule D). Based on your starting point of $10,000 and endpoint of $12,000, expect to pay taxes on $2000.

Maybe you should grab a real Schedule D and 8949 and fill it out for the trades you have done so far. Do a dry-run through the forms, and see how the numbers come out.

Capital losses carry forward - capital gains do not.

What would suck is if you had the $40,000 of capital gains in 2020, and then had $38,000 in capital losses in 2021. In that case, yeah, there's no way to carryforward capital gains to later tax years to cancel out losses then.

You are, however, allowed to carry-forward capital losses from year to year (and also deduct $3000/year of net losses). Hypothetically if you lost $38,000 in 2020 and gained $40,000 in 2021, you could deduct $3000 in 2020, carry $35,000 loss forward to 2021 and use it to cancel out $35,000 of the capital gains, paying tax on only $5000. (effectively paying the tax on the $3000 you avoided paying taxes on the year before).