If the recent uncertainty in the crypto market has caused you some losses in your investments, chances are you might benefit from them.
Paying tax helps build a nation but it also takes away a huge chunk of your income. With the dawn of crypto, a lot of people have found their new havens, realizing massive profits and a huge uptrend in their portfolios. But all that capital gain is waiting to be taxed the moment you make a trade or sale.
What if there was a way that could give you some wiggle room to save some money in taxes, Legally! Well, turns out, there is. A tax loophole that allows you to take hits in the form of losses and use it to minimize the burden on your tax filing through tax-loss harvesting.
How Does Tax Loss Harvesting Work?
It basically is a process to offset your taxes by taking some losses before the tax year ends. Since crypto is so volatile, you can take a relatively bigger loss and still manage to maintain the same portfolio. The only catch is, in some countries, you cannot buy back the asset you sold in the loss within 30 days.
Let’s take a look at this example to understand TLH in a much clearer way.
Nate bought 1 Ethereum at $4000 when the coin was at its top. 3 months later, the coin was trading at $2700. Now both have the opportunity to harvest the tax loss of the difference amount, $4000 - $2700 = $1300.
Nate sold his Ethereum and waited some time to invest in a similar asset. He then later bought assets that resulted in capital gains, Nate became entitled to claim his previous losses to offset his taxes on the capital gains.
The whole purpose of this tax loophole is to reduce the taxes on your capital gains by strategically taking advantage of the market volatility of cryptocurrencies.
Now Comes The Simplest Tricky Part:
If you’re buying back from the low, wouldn’t the profit from that price point result in higher taxes later on? And wouldn’t buying equivalent amounts of other cryptocurrencies result in net-zero? Well, yes but if it was that simple, no one would do it, would they?
There are different benefits like the short-term and long term, different asset types and definitely, there’s the time value.
For example, tax rates on short-term capital gains (within a year) are higher than tax rates on long-term gains. Because short-term gains are taxed at higher income tax rates compared to long-term investments, the taxes are higher. So the amount you’d pay in year one can be saved in year two as the capital gains would then fall under long-term investment.
However, if you realize a capital loss within a year of investment and if the loss is higher than the capital gains, you can completely offset the gains with losses, and if you still have some losses left, you can use those to reduce up to $3000 in your taxable income.
Things To Consider While Devising an Efficient Tax-Loss Harvesting Plan?
No matter how enticing tax-loss harvesting appears, if not implemented well, it may end up causing you losses instead. While creating a strategy, keep these points in mind:
a) You can take as many capital losses as you want to for tax deductions on your capital gains. But, you can only use up to $3000 of your losses against taxes on your regular income within a tax year. You can also benefit from time value as the taxes payable in the future would be lesser than the taxes you pay today.
b) Transaction costs should be kept in mind as they are equally important as saving money through tax reductions. Because each transaction, buying and selling, have some transaction costs, which if not considered correctly, could end up hurting your tax efficiency targets.
c) If you’re planning for your retirement and putting everything in a retirement account, tax loss harvesting isn’t for you. Retirement accounts are tax-deferred, hence, capital losses booked for the tax-loss harvesting purposes are useless.
d) Taxes can be deferred until your retirement using a TRDA or Tax-Deferred Retirement Account. If you have a decent and diverse portfolio, you can make use of tax-loss harvesting to minimize the taxes. Since you’d be paying taxes on your gains once you get retired, you could deviate from a higher tax bracket to a lower tax bracket and end up paying less taxes than you’d have while working.
How To Collect Transaction Insights And Create Reports For Tax Filing?
Nobody knows how many transactions they are going to make. It could be 4 or 100. Regardless of the numbers, you need to analyze your transactions to collect insights of your P&L (Profits and Loss). It can be done manually but that’s a tedious process and time is of the essence. So, how would you do it? Turns out there are businesses out there that let you do just that.
1. Accointing - A tool that lets the user track their transactions, keep an eye on the portfolio and prepare tax reports. The tax report then can be used to file taxes. A user needs to sign up with Accointing, then connect your accounts through your exchange’s API and the software will do the rest.
2. Token Tax - This is the software that fetches a user’s wallet through the provided API and automatically creates tax reports and tax-paying forms. Its algorithm calculates the gains and losses minus the transaction fees and evaluates how much the user owes to the tax department after tax-loss harvesting.
3. Koinly - A crypto tax calculator that allows its users to track and review their portfolios, check the amount invested and ROI on it and also create a tax report automatically. It also tells the users the tax liabilities by keeping all the data in one place.