- Bitcoin prices were down about 18% in December through Thursday. Other cryptocurrencies like ethereum also plunged this month.
- Crypto investors can use an investment loss to their advantage. Crypto transactions aren't subject to "wash sale" rules like stocks, mutual funds and other investments.
- This offers a dual benefit for crypto investors. Democrats may close the loophole if the Build Back Better Act passes in 2022.
Bitcoin took a beating in December — but that price plunge opens a tax loophole for investors.
The cryptocurrency lost about 18% this month through Thursday, with prices falling to about $47,000 per coin. Surging U.S. Covid cases in the U.S. were a major catalyst for the decline, which extended to other popular cryptocurrencies like ethereum.
However, crypto investors can take advantage of that loss in a way stock, mutual fund and other investors can't. That's because so-called wash sale rules don't apply to crypto transactions.
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Crypto investors reap a dual benefit from this arrangement.
First, they can sell crypto for a loss and claim a tax benefit. (That benefit comes via tax-loss harvesting, which lets investors use a loss to reduce or eliminate capital-gains tax owed on winning investments sold for a gain.) Second, investors can quickly buy back the crypto they sold to capture any rebound in price — which isn't far-fetched given crypto's volatility.
The first benefit is broadly available to investors, but the second isn't due to wash-sale rules. The anti-abuse rules prevent stock investors from buying an identical or similar security within 30 days before or 30 days after a sale without triggering penalties.
"It lets you completely manipulate [crypto] on the downside and use it to create a tax [benefit]," Leon LaBrecque, a certified financial planner and accountant at Sequoia Financial Group in Troy, Michigan, has told CNBC.
Of course, many bitcoin and other crypto investors may not have a loss on the books. Despite bitcoin's recent plunge, the coin was up about 62% in 2021 through Thursday — more than twice the return of the S&P 500 Index this year.
The IRS treats crypto as property, not as a security (like a stock or bond), which is how the asset class escapes wash-sale rules under present law.
While the dual benefit applies to cryptocurrencies like bitcoin, ethereum and dogecoin, it wouldn't for investors in crypto-related securities.
"You couldn't dodge the wash with [crypto platform] Coinbase," LaBrecque said. "But you clearly could dodge the wash with crypto."
Congress may soon close this tax loophole, though.
The House-passed Build Back Better Act, a roughly $1.75 trillion package of investments in social programs and climate-change mitigation, would subject crypto transactions to wash-sale rules. The legislation has stalled in the Senate amid objections from Sen. Joe Manchin, D-W.Va., a crucial swing vote in the evenly divided chamber.
Some elements of the legislation may change during negotiations.
Investors looking to take advantage of the crypto tax loophole may also inadvertently run afoul of existing rules if they're not careful.
Crypto sales must still have "economic substance" or investors risk the IRS labeling them "sham" transactions, Jeffrey Levine, CFP, accountant and chief planning officer at Buckingham Wealth Partners, based in St. Louis, has told CNBC.
The IRS essentially wants an investor to bear some economic risk for the sale — meaning some risk of loss, Levine said.
Investors who hit the bitcoin sell button and buy it back a second later risk the IRS negating the tax benefit. But the timing isn't black and white.
"Time is always your best argument," Levine said. "But given the volatility, and the fact it's constantly trading, I think you have much more flexibility with crypto than you do with anything else.
"A day is more than sufficient," he added. "I'd feel comfortable defending that to the IRS."
Even if crypto is ultimately subject to wash-sale rules, investors may be able to work around them by speedily establishing positions in a different coin without getting tripped up.
Cryptocurrencies are dissimilar enough that selling bitcoin and then quickly buying ethereum, for example, likely wouldn't violate the rules, according to Ivory Johnson, CFP, founder of Delancey Wealth Management in Washington, D.C.
"The similarities start and end with the coins being exchanged on a blockchain," Johnson has told CNBC. "Using that logic, stocks traded on an exchange, NYSE or otherwise, are not considered one and the same either."