Crypto Traders Have Short Window to Avoid House Tax Plan
(Bloomberg) -- Cryptocurrency investors would have little time to plan against possible tax increases under legislation advancing in Congress to treat digital assets like stocks and other securities.
House Democrats’ proposed tax-and-spend package would subject digital assets to two anti-abuse rules that already apply to stocks and other securities. The change would restrict tools crypto investors can currently use to hedge against potential losses and lower their capital gains taxes.
A provision applying “constructive sale” rules to digital assets would take effect as soon as the bill is signed into law. The rules would kick in when investors take offsetting short and long positions on an asset to reduce the risk of losing money. Once the offsetting positions are taken, they would have to pay capital gains taxes on the long position as if it was sold—even if it wasn’t.
Cryptocurrency investors would also have to worry about “wash sale” rules beginning in 2022. Those rules bar investors from claiming a deduction when they sell an asset at a loss if they buy a “substantially identical” asset within 30 days before or after the sale.
The new rules for digital assets are part of a host of tax code changes Democrats are looking to put into effect quickly, leaving individuals and corporations without much time to react. But there’s at least a small window, which is more than investors got in 1997 when the constructive sale rules were first enacted on a retroactive basis.
Crypto investors with offsetting positions will want to consider liquidating both positions or at least selling one to avoid being hit with capital gains taxes under the constructive sale rules, said Shehan Chandrasekera, head of tax strategy for CoinTracker, a company that helps people manage and calculate taxes from their cryptocurrency transactions.
Investors hoping to capitalize on tax savings before the wash sale rules take effect will have two months to “aggressively tax-loss harvest,” Chandrasekera said, referring to the strategy of selling cryptocurrency assets at a loss, then buying them back at a lower price to reduce future capital gains taxes.
Investors will need to be careful, however, when carrying out transactions at the end of this year and into next year, said Lisa Zarlenga, a partner at Steptoe & Johnson LLP who advises clients on issues pertaining to the blockchain and digital assets. Selling a cryptocurrency asset at a loss in early January may inadvertently trigger the wash sale rules if an investor purchased a nearly identical asset less than 30 days before in December, she noted.
Congress’s official tax scorekeeper, the Joint Committee on Taxation, estimated Thursday that the changes to the constructive sale and wash sale rules would collectively bring in about $16.8 billion over 10 years.
The House could vote on its reconciliation package as soon as Friday after making a handful of last-minute changes. That would ready the bill for the Senate, which is expected to make changes before passage.
The provisions on wash sales and constructive sales are similar to ones included in a proposal advanced by the Ways and Means Committee in September. They are separate from reporting requirements that would be imposed on cryptocurrency brokers, such as exchanges, under the Senate-passed bipartisan infrastructure deal that the House may also consider Friday.
Once the provisions take effect -- assuming they remain in the final reconciliation package -- it would be “very, very complicated” for cryptocurrency investors and their financial advisers to comply with the rules, Chandrasekera said, noting key characteristics that differentiate cryptocurrency from other financial assets.
Cryptocurrency transactions happen more frequently than those involving stocks and other securities and often across multiple wallets and exchanges, making them more difficult to track, he said. CoinTracker has found the average person has three to five wallets and exchanges. In addition, there are platforms that have made it easy for the average person to engage in complex financial transactions, such as shorting, with their digital assets, Chandrasekera said.
The House’s bill would also extend the wash sale rules to foreign currency and commodities, but Zarlenga predicted there would be an “outsized impact” on digital assets.
She noted that the bill would provide a carveout for certain business transactions involving sales of foreign currency or commodities -- but not digital assets.
There is also an increased risk that the wash sales rules will be triggered unintentionally by trades of “gateway” coins, like Bitcoin or Ethereum, that are bought and sold much more frequently than others, Zarlenga said. A user might convert Ethereum, for example, to a decentralized finance platform’s native token in order to gain access that platform.
“There are going to be so many transactions, and it’s going to be so hard to potentially monitor,” she said.
Many of the industry’s key questions about the proposed legislative changes wouldn’t get answered until the IRS and Treasury Department put out guidance interpreting the law.
It isn’t clear in the legislation how “substantially identical” will be defined under the wash sale rules, Zarlenga said. Some may assume an investor would have to buy and sell the same cryptocurrency, such as Bitcoin, but it is possible the definition could be broader, she said.
Coinbase, the largest U.S.-based crypto exchange, said it would push Treasury and the IRS to adopt “sensible and tailored” regulations for cryptocurrency.
“As more and more Americans embrace digital assets, these rules should not be overly broad such that they stifle innovation or place unworkable requirements on citizens,” the company said in a statement.
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