In recent months, the Internal Revenue Service (IRS) has made it clear that, in their view, selling crypto for fiat currency is a taxable event that requires reporting and tax payment. And they make no distinction when it comes to crypto swaps (cryptocurrency-to-cryptocurrency exchanges).
In fact, the IRS treats crypto swaps in nearly the same manner that it does crypto sales for fiat currency - both require reporting and payment. However, the tax payment requirement assumes that the crypto swap in question results in a capital gain. The regulations are different if the swap results in a crypto loss.
In this article, we will explain crypto swap tax treatment in general as well as provide explanations and strategies to help you with crypto swap loss tax reporting.
In short, crypto swap losses must be reported on your taxes. So long as the crypto swap loss is realized (realized and unrealized crypto swap losses will be discussed later in this article), a taxable event has occurred. In general, crypto swaps are subject to taxation, but in the case of a crypto swap loss, there is simply no income (also referred to as a capital gain) for the government to tax.
Although the IRS requires you to report crypto swap losses, it also allows you to write-off some or all of your losses. However, there are specific regulations detailing the way in which capital losses offset capital gains. Short-term capital losses first offset short-term capital gains. Likewise, long-term capital losses first offset long-term capital gains. Should you have any net capital losses remaining, those losses can be used to offset either short-term or long-term capital gains. If you reach the maximum amount of capital loss write-offs for the current tax year, you may be able to write-off some or all of the remainder of the loss in future years.
Let’s start the discussion off with a brief description of crypto tax treatment generally before moving on to explain some of the nuances related to crypto loss tax treatment. We recommend learning the basics of crypto tax treatment first, as this knowledge can really help when trying to understand how to report your crypto swap capital gains and losses.
Crypto Tax Treatment
The IRS treats cryptocurrency assets like property rather than currency. In terms of tax treatment, cryptocurrency is most similar to stocks and bonds. As a result, “...the money you gain from crypto is taxed at different rates, either as capital gains or as income, depending on how you got your crypto and how long you held on to it.” However, not every crypto transaction is taxable. In order to be taxable, a taxable event must occur.
As a result, determining crypto tax liability is a multi-step process that requires you to analyze crypto tax law generally, as well as how you received and used the crypto in question. And in some instances, the amount of tax owed is determined by your business structure or personal income tax bracket.
When crypto is sold or otherwise disposed of within a year from the original receipt date, standard income tax rates apply (this scenario is often referred to as a short-term capital gain). This means that any gains that you make from short-term crypto trades will be taxed at a rate that corresponds to your individual, joint, or business income tax rate.
On the other hand, if you hold your crypto for longer than one year before disposing of it, you will benefit from the federal long-term capital gains tax rate. In most instances, the long-term capital gains tax rate is appreciably lower than individual income tax rates.
(For a full breakdown of crypto tax rates, check out our blog article titled, “Is Trading One Cryptocurrency For Another A Taxable Event?”)
In general, capital gains tax rates are not applicable when you suffer a capital loss. However, capital losses can be deducted on your taxes by offsetting your capital gains (more on this later in the article). As a result, it is important to understand the specifics of capital gains taxes in order to fully benefit from the capital loss regulations built into the tax code.
Step-By-Step Outline To Determine Crypto Tax Liability
The following high-level questions can help you determine your crypto tax liability. When applied properly, they can help you figure out whether you owe taxes on your crypto trades as well as the rate you can expect to pay. Begin by asking yourself:
- Did a taxable event occur (see “what is a taxable event?” below)? If yes,
- Was the crypto used in a way that creates capital gains tax liability or income tax liability?
- If the crypto was used in a way that creates capital gains liability, is the capital gain short-term or long-term?
- If the crypto was used in a way that creates income tax liability, what is your income tax rate?
- Determine your capital gains tax rate and/or income tax rate and report your crypto gain or loss.
What is a taxable event?
Many common types of crypto transactions constitute a taxable event. These common crypto transactions do incur tax liability and should be reported to the IRS:
- Receiving crypto as payment for work
- Receiving crypto as payment for goods or services
- Receiving crypto rewards for crypto mining
- Receiving staking rewards for crypto staking
- Selling crypto for fiat currency
- Using crypto to pay for goods and services
- Swapping or exchanging one type of crypto for another (cryptocurrency-to-cryptocurrency swaps)
- Earning other crypto income, rewards, incentives, etc.
On the other hand, there are several kinds of cryptocurrency transactions that do not constitute a taxable event and, therefore, do not trigger tax liability. In general, the following types of crypto transactions are not taxed:
- Buying crypto with cash and holding it
- Donating crypto to a tax-exempt charity or non-profit organization
- Receiving crypto as a gift
- Giving crypto as a gift
- Transferring crypto to yourself (e.g., you can transfer cryptocurrency to your other wallets and accounts without creating a taxable event)
As mentioned above, crypto swaps create a taxable event and are subject to taxation. However, crypto-to-crypto swaps that result in a capital loss do not require tax payments. These types of transactions are not immune from taxation; strictly speaking, it’s just that there is no income to tax. In other words, a taxable event has occurred, but there is no capital gain for the government to tax. So, crypto-to-crypto swap losses should be reported on your taxes even though no tax payment is required.
Next, let’s discuss how to calculate a crypto-to-crypto swap loss.
Cryptocurrency-To-Cryptocurrency Swap Taxes
To review, not all crypto transactions are subject to taxation. In order to be taxed, a crypto transaction must constitute a taxable event. As mentioned above, crypto swaps (crypto-to-crypto exchanges) do constitute a taxable event and must be reported. However, the question remains, how exactly do you go about reporting a crypto swap loss? To start, let’s discuss how to determine if you have suffered a crypto swap loss and how to calculate the capital loss to report on your taxes.
How do you calculate capital gains or losses for crypto-to-crypto swaps?
Capital loss (or gain) in crypto-to-crypto swaps can be determined by calculating the difference between the cost basis (e.g., the purchase price of the original crypto asset) and the fair market value of the crypto being acquired (e.g., the purchase price of the second crypto).
The capital gain/loss in crypto-to-crypto swaps equals the price of the acquired crypto asset minus the cost basis (purchase price or fair market value of the original asset when you received it). For example, if you purchased Ethereum worth $4,000 that decreased in value to $3,000 by the time you exchanged it for Bitcoin, then your total capital loss would be $1,000 ($3,000 - $4,000 = $1,000). In that scenario, you would report a capital loss of $1,000 on your taxes for the crypto-to-crypto swap.
Realized vs. Unrealized Capital Losses
Taking a loss on an investment is not ideal, but it does come with a few silver linings. The most important benefit that can come from a crypto-to-crypto swap loss is that you can write off the capital loss on your taxes.
However, when calculating capital losses, it is important to remember that a loss must be realized in order for it to be written off. The requirement that a loss must be realized is just another way of saying that a taxable event must occur. As a result, you must dispose of your original crypto in order for the loss to be realized.
Here are a few common examples of ways in which investors dispose of their crypto:
- Selling crypto for fiat currency (e.g., US Dollars)
- Using crypto to pay for goods or services
- Swapping one type of crypto for another type of crypto (crypto-to-crypto swaps)
In practice, this means that a capital loss can’t be written off if the crypto is simply bought and held. For example, if you bought Bitcoin for $20,000 and it later decreased in value to $16,000, you can only write off the loss if you have disposed of the Bitcoin. If you are simply holding the Bitcoin, this is what’s referred to as an unrealized loss. The unrealized loss should not be reported or written off on your taxes because a taxable event has yet to occur.
In the case of a crypto-to-crypto swap, a taxable event has occurred when one crypto is swapped for another (considered a disposal of the crypto). Accordingly, any loss that results from the swap is a realized loss that should be reported and potentially written off on your taxes. Returning to the example above, if you bought Bitcoin worth $20,000 and later swapped the Bitcoin for $16,000 worth of Ethereum, you have a realized capital loss of $4,000 that should be reported and hopefully written-off on your taxes.
What is the maximum amount of crypto swap losses you can write off on your taxes?
Crypto-to-crypto swaps are subject to Internal Revenue Service (IRS) regulations regarding capital gains and losses. Under IRS rules, there is a maximum amount of capital losses that you can write off on your taxes each tax year.
Based on current regulations, capital losses can offset all of your capital gains and up to $3,000 of personal income. For example, if you have a total amount of $5,000 of capital gains for the year before you swap Bitcoin for Ethereum at a loss of $6,000, then you can write off all of your capital gains for the year as well as a total amount of $1,000 of personal income.
Any amount over the $3,000 personal income write-off limit can be carried forward to the next tax year. For businesses, the maximum capital loss write-off is determined by your business structure (sole proprietorship, general partnership, limited liability company, corporation, etc.). However, many businesses are considered pass-through entities for tax purposes, meaning that business income is passed through to the owners of the business in order to avoid double taxation. Accordingly, owners of pass-through businesses will have the same maximum tax write-off amount as the maximum write-off amounts listed above for individuals.
Do capital losses offset short-term capital gains, long-term capital gains, or both?
As discussed earlier, crypto swap gains are taxed at a different rate depending on how long the original asset is held. Capital gains on crypto that is held for less than a year before swapping are considered short-term capital gains, while capital gains on crypto that is held for more than a year before swapping are considered long-term capital gains.
If you have capital losses in addition to your capital gains, the question becomes whether the capital losses offset short-term capital gains, long-term capital gains, or both. While the distinction may seem trivial at first glance, the answer could change your tax bill significantly due to the difference in tax rate between short-term and long-term capital gains. Because short term capital gains are taxed at a higher rate than long-term capital gains, it is advantageous to write off as many short-term capital gains as possible.
As it turns out, capital losses are also classified as either short-term or long-term. Capital losses on crypto that is held for less than a year before swapping are considered short-term capital losses, while capital losses on crypto that is held for more than a year before swapping are considered long-term capital losses.
With regard to tax write-offs, short-term capital losses first offset short-term capital gains. Likewise, long-term capital losses offset long-term capital gains first. Should you have any net capital losses remaining, those losses can be used to offset either short-term or long-term capital gains. In other words, “short-term capital losses are calculated against short-term capital gains … to arrive at the net short-term capital gain or loss. And, “... your net long-term capital gain or loss is calculated by subtracting any long-term capital losses from any long-term capital gains.
The next step is to calculate the total net capital gain or loss from the result of combining the short-term capital gain or loss and the long-term capital gain or loss.”
Can you carry over crypto swap losses to future tax years?
Suppose after subtracting your net total capital loss from your net total capital gain, you are left with a negative number. In this instance, you would have a net total capital loss even after writing off all of your gains.
The good news is that you may be able to write off additional amounts beyond just the total amount of net capital gains. In fact, “If the total net figure between short-term and long-term capital gains and losses is a negative number, representing an overall total capital loss, then that loss can be deducted from other reported taxable income, up to the maximum amount allowed by the Internal Revenue Service (IRS).”
As stated earlier, the maximum write-off on personal income is $3,000 for those who are single or married filing jointly and $1,500 for those who are married and filing separately. The maximum amount of tax write-off for businesses is determined by their business structure.
In addition, “If your net capital loss is more than the maximum amount, you may carry it forward to the next tax year. The amount of loss that was not deducted in the previous year, over the limit, can be applied against the following year's capital gains and taxable income.” Additionally, if the loss is very large, you can apply the loss to the maximum write-off amount in subsequent tax years until the entire amount has been written off.
What tax forms do you need to file in order to claim a crypto swap loss?
As discussed above, the first step in filing a capital loss is calculating your net total capital loss amount. Once you have calculated the net total capital loss amount, the next step is obtaining the proper forms from the IRS. For individuals, you will want to download IRS form 8949 and complete Schedule D on your individual income tax return form 1040 or form 1040-SR (form 1040-SR is simply an alternative form 1040 for individuals above the age of 65) in order to claim a capital loss.
Crypto Tax Loss Harvesting
Crypto losses happen to all investors at some point. Thus far, we have discussed the best tax break options to employ after suffering a capital loss. However, one additional strategy is worth mentioning - tax loss harvesting. Tax loss harvesting involves intentionally realizing a crypto loss. “Tax-loss harvesting is a strategy used by investors to lower their capital gains tax liability to the U.S. government.
To use this strategy, an investor will sell an investment at a capital loss to take advantage of timing in the market or for the tax year. The loss can then be used to offset capital gains from other assets that produced a profit or to offset future gains from that same investment or other profitable trades.” Tax loss harvesting has become a popular practice amongst crypto investors as well as investors in other asset classes. In fact, crypto “...losses can be used to decrease the tax liability on other asset classes, such as stocks, bonds, and real estate.”
The Wash-Sale Rule
When employing a tax loss harvesting strategy, the wash-sale rule is something that you should be aware of. “The wash sale rule prevents investors from selling a stock at a loss, then repurchasing a ‘substantially identical’ asset in the 30 days before or after the sale. So you couldn’t sell 100 shares of XYZ stock on Monday, then turn around and buy 100 shares of that same stock on Tuesday and still be able to harvest any associated tax losses.”
The wash-sale rule is designed to prevent the sale of assets by individuals and businesses that are simply trying to claim tax benefits without ever intending to dispose of the asset. While the wash-sale rule does not stop the tax loss harvesting process altogether, it inserts some additional risk for those who are trying to gain tax advantages. After all, there is certainly a chance that the asset in question increases in value substantially during the 30-day waiting period making it impossible for the original investor to get back into the asset at the price they sold it for. In this scenario, the investor would gain a tax advantage but lose out on the capital gain that takes place during the 30-day waiting period.
Interestingly enough, the wash-sale rule applies to securities and not to property. Because crypto is considered a form of property by the IRS, the wash-sale rule does not apply to crypto assets at the present time. This means that you can still sell crypto for the tax harvesting benefits and re-purchase the same crypto without waiting the required 30 days under the wash-sale rule.
However, this anomaly is considered by many to be a tax loophole that Congress is intent on closing in the near future. As a result, crypto investors should take caution when depending upon a tax loss harvesting strategy going forward. In addition, many experts believe that excessive crypto tax loss harvesting could draw unwanted IRS attention and perhaps even violate the IRS’ Economic Substance Doctrine.
The Economic Substance Doctrine “...disallows tax benefits for a transaction if the said transaction has no economic substance nor business purposes. Essentially, this doctrine states that in order for a transaction to be valid, it must have an economic purpose other than reducing tax liability, and it also must have an effect other than its tax effect.”
When considering the wash-sale rule and the Economic Substance Doctrine, it seems that a conservative strategy for crypto tax loss harvesting is to enjoy the tax benefits sparingly. In addition, it is probably prudent to follow the wash-sale rule whenever possible, even though it currently does not apply to crypto assets.
Bitwave Is The Crypto Tax Solution You Have Been Searching For
As you might be able to tell, crypto taxes can be a bit tricky. But they are a lot easier when all of your trading activity is recorded, organized, and tabulated - ready to be entered into your tax forms. Bitwave can do all of that and more. Our software can even calculate and track cost basis, gains, and losses for short-term and long-term capital gains.
With Bitwave’s help, your crypto swap tax preparation process can go from a time-consuming headache to a few clicks of a mouse. Give us a call or send us a quick email and let us show you how Bitwave can effortlessly handle your complex crypto tax scenarios.