In prior articles in the US Tax Considerations series, we touched upon how the IRS views the STEEM and STEEM Based Dollars earned on Steemit (earned income), we learned also how to properly value those earnings and we learned how to calculate any capital gain we made in the event we sold the crypto for more than it we originally valued it (a capital gain). Suppose the market turns and we need to sell at a loss so we can move to the sideline and preserve capital. What do the tax laws say for this?
It turns out there are a whole set of rules related to this scenario as well. In this piece, we will take a very generalized view of how these rules apply to the individual.
Let’s take a closer look at capital loss rules.
But First, The Required Legalese…
Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.
Capital Loss Rules
Generally speaking, when capital property is disposed of, in this case, when crypto is traded for dollars, either the amount realized (amount of dollars received from exchange) exceeds basis and a capital gain is recognized, or the amount realized is less than basis and a capital loss is recognized.
In this round of US Tax Considerations, we will discuss what happens when the sale price of the capital asset realized is less than the basis and a capital loss is recorded.
Classification of Capital Losses (Short Term or Long Term)
Capital gains and losses fall under two distinct categories: Short Term Capital Losses and Long Term Capital Losses. The distinction is important:
Short Term Capital Losses these are capital losses that result when the sale price of a capital asset (such as a cryptocurrency for purposes of this discussion) is lower than the basis (for purposes of this discussion basis will be the price paid for the cryptocurrency in USD) and the sale occurs within a period of one year and one day or less.
For example, suppose we purchase 100 STEEM tokens for 1,000 USD, or 10 USD per token. Now imagine we see the value of STEEM dropping and we decide we want to preserve our capital, so we sell all 100 tokens for 800 USD, or 8 USD per token approximately 8 months after we purchase them.
Because the cost per token (10 USD) is greater than the sale price per token (8 USD), a capital loss is realized. Also, because we sold the STEEM tokens before one year and one day had passed, the capital loss is considered to be a Short Term Capital Loss.
Long Term Capital Losses these are capital losses that result when the sale price of a capital asset (such as a cryptocurrency for purposes of this discussion) is lower than the basis (for purposes of this discussion basis will be the price paid for the cryptocurrency in USD) and the sale occurs in a period of greater than one year and one day.
Let’s look at the same example as before, but let’s change only when the asset was sold.
For example, suppose we purchase 100 STEEM tokens for 1,000 USD, or 10 USD per token. Now imagine we see the value of STEEM dropping and we let the losses run with the hope of greener pastures in the long term. After 53 weeks from the date of purchase, we decide to throw in the hat, resigned to just eat the loss and hope for a new entry point; so we sell all 100 tokens for 800 USD, or 8 USD.
Because the cost per token (10 USD) is greater than the sale price per token (8 USD), a capital loss is realized. Also, because we sold the STEEM tokens after one year and one day had passed (we sold at one year and one week), the capital loss is considered to be a Long Term Capital Loss.
Capital Losses Have an Order of “Use”
In the world of mathematics, operations (addition, subtraction, multiplication and division) have an order, and the rules to this order are called (very inelegantly) the Order of Operations. For US Income Tax Capital Losses, there is something similar. And the order goes something like this (in a very general way):
General Rule #1: Capital Loss Types Must be Netted Against Similar Capital Gain Types
I see the confused look on your face, so let’s walk through it.
Imagine we had both loss types from the examples in the previous section: a 200 USD Short Term Capital Loss and a 200 USD Long Term Capital Loss. This rule would require us to first look to see if we had any Short Term Capital Gains (capital assets we profitably sold for which our holding period was one year and one day or less) and/or any Long Term Capital Gains (capital assets we profitably sold for which our holding period was more than one year and one day).
For purposes of this example, let’s suppose we sold some Bitcoin we held for 2 years and we recognized a Long Term Capital Gain of 200 USD (because we held it for more than one year and one day before we sold). Let’s also assume we had some Ethereum that absolutely shit the bed after the hardfork, which we promptly dumped about 3 months after purchase on a dead cat bounce for a Short Term Capital Gain of 600 USD.
This rule says we need to take the Short Term Capital Gain and net it against the Short Term Capital Loss (600 USD – 200 USD) leaving a Short Term Capital Gain of 400 USD. In the same way, The Long Term Capital Gain is netted against the Long Term Capital Loss (200 USD – 200 USD) leaving a Long Term Capital Gain of 0 USD.
General Rule #2: Once Capital Losses are Netted By Similar Type, They Are Then Netted Against Each Other
Under this general rule, we would take the Short Term Capital Gains/Losses and net them against the Long Term Capital Gains/Losses and…then what? Good question. The answer is it depends upon what that net value is. Let’s take a look at the different scenarios:
Short Term Capital Gain Netted Against Long Term Capital Loss Imagine after all our bean herding and calculating, we find we have a Short Term Capital Gain of 600 USD and a Long Term Capital Loss of 200 USD, we would net the two of them (600 USD – 200 USD) which would give us a remaining Short Term Capital Gain of 400 USD. Since it’s a Short Term Capital Gain, it would be taxed as ordinary income.
Short Term Capital Loss Netted Against Long Term Capital Gain In this scenario, after bean herding and calculating, we discover we have a Short Term Capital Loss of 200 USD and a Long Term Capital Gain of 600 USD. We would net the two of them (-200+600) which would give us a remaining Long Term Capital Gain of 400 USD. Since it’s a Long Term Capital Gain, it would be taxed at more favorable Long Term Capital Gain tax rates.
Short Term Capital Gain/Loss Netted Against Long Term Capital Gain/Loss Nets Negative Value In this scenario, we have a situation where either a Short Term Capital Gain is less than a Long Term Capital Loss, a Long Term Capital Gain is less than a Short Term Capital Loss or there is both a Short Term Capital Loss and a Long Term Capital Loss.
The result of all these netting scenarios is a net capital loss. This net capital loss is considered different from ordinary income for tax purposes and must be bled over time against earned income. In a given tax year, only $3,000 of this capital loss may be used against earned income, while any remainder is carried forward to the next year. Capital losses are not subject to carryback rules for individuals.
For example, suppose our Net Capital Loss for the year is 10,000 USD. We would be permitted to take a 3,000 USD deduction against earned income in the same year and we would carry forward a capital loss of 7,000 USD to use against future capital gains and/or be bled out against earned income in future years.
Wash Sale Rules
Some types of capital properties, such as securities are subject to Wash Sale Rules. The gist of the rule is when we sell a stock or security for a loss, we cannot purchase the same stock or security for 31 days or the loss will be disallowed.
Wash sale rules do not apply to cryptocurrency trading.
Wrapping It Up
Sometimes the crypto marketplace can be rather unforgiving, and necessitates a sale at a loss. Be aware of how the capital loss rules impact the tax position of the sale and consider that when formulating your investment and crypto exchange strategy.
Have a tax question? Please feel free leave a question in the comment section below and I may feature it in a future blog post or email me ustaxationsolution@gmail.com
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