The popularity of cryptocurrencies or virtual currencies continues to draw the attention of federal lawmakers. Legislation currently being proposed would treat digital assets such as cryptocurrency the same as stock and securities in the applying the wash sale and constructive sale rules for federal income tax purposes.
In terms of the wash sale rule, this would limit a taxpayer’s ability to lock-in or harvest losses by selling an investment in cryptocurrency at loss (for example, at the end of the year) with the intention of immediately repurchasing it (beginning in the new year). Similarly, the constructive sale rule would limit a taxpayer’s ability to try to avoid short-term capital gains in an appreciated position in cryptocurrency by entering an offsetting hedging transaction.
Wash Sale Rule
Under the wash sale rule, a loss on the sale of stock or securities is not deductible if the taxpayer acquires substantially identical stock or securities within 30 days before or after the sale (61-day period). The disallowed loss is simply deferred and not permanently lost. Rather, it is generally added to the basis of the newly acquired stock or securities.
For example, assume Nikki purchase 100 shares of X company stock on January 15, 2021 for $6,000. She sells all 100 shares of X stock on December 15, 2021 for $5,000 realizing a $1,000 loss. On January 10, 2022, she purchases another 100 shares of X stock for $5,500. Because Nikki purchased stock in the same company during the 30-day period before or after the date of sale on December 15, 2021, she may not deduct the $1,000 loss. Instead, her basis in the stock acquired on January 10, 2022, is increased to $6,500.
Cryptocurrency and Wash Sales
Under current law, the wash sale rules applies only to stock or securities, as well as contracts or options to acquire or sell stock or securities. Cryptocurrency or virtual currency is classified as property by the IRS. Thus, it is not currently subject to the wash sale rule. An investor in a virtual currency could sell his or her position to recognize a loss for tax purposes even if he or she repurchases it within the 61-day period around the sale.
Proposed legislation would change this beginning in 2022. Under the proposal, the wash sale rule would apply to any digital representation of value (cryptocurrency or virtual currency), including contracts and options to acquire the virtual currency. Like wash sales or stock or securities, the taxpayer would add the loss denied to the basis of the newly acquired virtual currency.
Constructive Sale Rules
In addition to the wash sale rules, proposed legislation would also make digital assets such as cryptocurrency subject to the constructive sale rule under IRC §1259. Under this rule, an appreciated financial position (the long position) is treated as constructively sold if the taxpayer enters an offsetting financial position of substantially identical property.
This rule prevents the use of hedging strategies like short sales against the box, notional principal contracts, and futures or forward contracts to offset potential gains without immediate recognition of income. Without the rule, a taxpayer could delay the realization of gains on his or her long position through these transactions and avoid the higher tax rates on short-term capital gains.
If a constructive sale of an appreciated financial position occurs (certain exceptions apply), IRC §1259 provides that the taxpayer recognizes gain (but not loss) as if the position were sold, assigned, or otherwise terminated at its fair market value on the date of the constructive sale. The holding period of the position is determined as if the position were originally acquired on the date of the constructive sale. Any gain or loss realized when the taxpayer sells or disposes of the financial after the constructive sale is adjusted to reflect any gain recognized under the §1259 rules.
Appreciated Financial Position
An appreciated financial position is generally any financial position with respect to any stock, debt instrument, or partnership interest where there would be gain if the position were sold, assigned, or otherwise terminated at its fair market value. Digital assets such as cryptocurrency would be added to the definition of an appreciated financial position under the proposed legislation. Like other financial positions, the constructive sale rules would not apply if the cryptocurrency is not publicly traded but only if the contract for the offsetting position does not settle within one year.
Reporting Cryptocurrency Transactions
If these proposals are enacted, a taxpayer would need to carefully track their transactions in cryptocurrency, as well as their basis. This would be especially important if the taxpayer uses multiple cryptocurrency exchanges or wallets.
New reporting requirements for cryptocurrency were already enacted by recent legislation. Brokersare required to report cryptocurrency transactions on Form 1099-B, included a customer’s basis, beginning after 2023. In addition, digital assets are treated as cash for purposes of the rules that require information reporting from any person that receives cash transfers of more $10,000 in a trade or business.
