Tax-Loss Harvesting with Cryptocurrencies

Abstract

We describe the landscape of taxation in the crypto markets, especially that concerning U.S. taxpayers, and examine how recent increases in tax scrutiny have led to changes in trading behavior by crypto traders. We predict under a simple theoretical framework and then empirically document that increased tax scrutiny leads crypto investors to utilize legal tax planning with taxloss harvesting as an alternative to non-compliance. In particular, domestic traders increase taxloss harvesting following the increase in tax scrutiny, and U.S. exchanges exhibit a significantly greater amount of wash trading. Additional findings suggest that broad-based and targeted changes in tax scrutiny can differentially affect crypto traders' preference for U.S.-based exchanges. We also discuss other gray areas for tax regulation related to new crypto assets such as Non-Fungible Tokens and Decentralized Finance protocols that further highlight the importance of coordinating tax policy and other regulations.

Taxing Cryptocurrencies

“…While there is thus some comfort in these results, it is far from complete. Cong et al (2022) look for signs of tax compliance by exploring the extent to which US-based crypto owners harvest tax losses around year end; that is, sell crypto and immediately repurchase so as to realize losses while leaving their holding unchanged-a transaction that would be hard to rationalize other than one of tax planning. (For traditional securities, such harvesting is restricted by disregarding repurchases within 60 days of the sale; as one of the gray areas in the precise details of the taxation of crypto, however, this restriction was not believed to apply to crypto.)…”

“…(For traditional securities, such harvesting is restricted by disregarding repurchases within 60 days of the sale; as one of the gray areas in the precise details of the taxation of crypto, however, this restriction was not believed to apply to crypto.) 67 Using both proprietary data from 500 large retail traders and data from 34 exchanges, 68 Cong et al (2022) find that such crypto transactions do occur and moreover increase following public statements by the IRS highlighting tax obligations on crypto transactions and its intention of targeted enforcement efforts. The conclusions to be drawn from this, however, are somewhat mixed: while there is a degree of compliance, the impact of policy statements by the IRS suggests that, whether willful or the product of ignorance, there is, or at least has been, a consequential element of non-compliance.…”

“…The application of reporting rules to domestic institutions may, however, drive transactions to either domestic mechanisms not subject to those rules or foreign ones that do not provide information to the domestic tax authorities. Cong et al (2022) see signs of the latter effect at work in the US, finding that while IRS actions aimed at US taxpayers in general 88 appeared to increase legal avoidance activity in crypto markets, actions targeted at a specific US exchange (Coinbase) decreased activity on US exchanges. 89 In the UK, 22 percent of survey respondents in HMRC (2022a) indicated that they preferred using foreign exchanges.…”