Crypto has recently experienced a rollercoaster ride. Bitcoin's price fell by about half in the last six months, wiping out billions of dollars in market value. However, many knowledgeable crypto investors probably don't give a damn. Why? These crypto titans employ a unique form of financial alchemy to generate enormous gains even when the cryptocurrency markets decline. Additionally, they operate tax-free. It is entirely legal (for the time being, at least), and is made possible by a flaw that is not readily apparent.

 

We need to look at Defi, tax policy, and the peculiar characteristics that drive crypto markets to comprehend how their process functions.

 

Selling Coca-Cola

Imagine that a shareholder purchases a common stock, such as Coca-Cola. Following a poor quarter, the company's stock price declines. Shares are sold by our investor at a loss. Our investor can then deduct her capital loss from her taxes. (Just a reminder that this post isn't designed to provide tax or investment advice; for information specific to your individual tax and investing situation, consult a professional advisor.)

 

In essence, she can use her investment loss on Coca-Cola stock to offset any other portfolio gains or even a portion of the income she received from her work. By allowing capital loss deductions, the IRS lessens the impact of financial hardship.

 

However, our investor is not permitted to purchase Coca-Cola, sell it for a loss, deduct the loss from her taxes, and then purchase more Coca-Cola stock right away. That is prohibited and is referred to as a "wash sale." Investors must wait 30 days after selling shares of the majority of traditional securities before repurchasing them in order to avoid losing their tax benefit.

 

The wash sale principle is reasonable. Without it, investors would continually buy and sell stocks in an effort to receive tax breaks when the market fell rather than actually quitting their investment. Yes, they would sell a little portion of their Coca-Cola stock whenever the market fell. 

 

Washing Bitcoins

But here's the deal. Only financial securities are subject to the wash sale prohibition. And ever since a crucial ruling in 2014, the IRS has regarded virtual currencies as property rather than genuine money or financial securities. They are therefore handled differently than a stock or bond, more akin to a yacht or a bar of gold.

 

Another benefit of the "property" label is that, unlike financial instruments, cryptocurrencies are typically exempt from the wash sale regulation in the US. As a result, investors can gladly sell them, deduct the loss from their taxes, and then promptly repurchase the same coins without running afoul of the law. That's a big problem for knowledgeable cryptocurrency investors.

 

Let's say our hypothetical investor purchases $1 million worth of Bitcoin. Her Bitcoins are now worth $500,000 as the price falls by 50%. She sells them, securing a $500,000 tax loss, and then buys them again right away. Her Bitcoins are now worth $1,000,000 after the coin's price soars in 9 months. That possibility is entirely plausible given the fluctuations of Bitcoin in only 2020.

 

Our investor has made a $100,000 profit. She is still permitted to deduct a $500,000 capital loss from her taxes as a result of the wash sale, though. Once more, she can carry some of that loss forward to future years or use it to offset gains in another area of her portfolio.

 

She can avoid the 20% capital gains tax on that $500,000 if she is in the highest tax bracket (after all, she has $1 million to invest in Bitcoin), which will result in a tax savings of $100,000. And that's in addition to the $100,000 she earned from the increase in value of her coins.

 

In other words, she can make significant financial gains while still deducting a sizable loss from her taxes.

 

On the Upside

But there's a catch, right? Our investor reset her cost basis when she sold and then repurchased her coins for $500,000. If she sells her bitcoins at their current value of $1,100,000, she will still owe taxes on the full $600,000 gain since her first sale. The tax advantages of the wash sale should be compensated by that, right?

 

Only if she sells her coins in fact. Many major cryptocurrency investors decide to keep their coins permanently rather than selling them. They use their cryptocurrency assets as collateral when taking out loans when they require access to money. They never pay taxes on the gains from their coins since they never truly sell them.

 

Major cryptocurrency exchange Coinbase even promotes this as a key component of their product. They will support your loan with your crypto assets and lend you up to $1 million in actual money. Their technology allows users to "borrow from Coinbase to earn cash without selling your Bitcoin," presumably to avoid these taxable occurrences, because "selling Bitcoin might result in a taxable gain or loss." You can even get a mortgage through other sites, like Figure, based on your cryptocurrency holdings.

 

Good Volatility

The fact that cryptocurrencies have a special tax classification, as well as the rise of Defi and crypto lending, helps to explain why savvy cryptocurrency investors don't give a damn if the market crashes.

 

If the markets decline, they will make a wash sale, take a huge loss, and save a bundle on taxes before waiting for the market to rebound. When their coins do increase in value, renting them out or using them as security for a cash loan will allow them to avoid paying taxes while still receiving all the money they require.

 

We hope that this blog post will be beneficial for you. We will continue to create useful works in order to get inspired by everyone. We are sure that we will achieve splendid things altogether. Keep on following Finage for the best and more.

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