How Crypto Investors Are Using ‘Wash Trading’

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To say the crypto market has taken a beating in 2022 would be the biggest understatement of the year. Unfortunately for crypto investors, this has translated into huge losses and a bruised confidence in the space.

There is, however, a strategy some are using at the end of the year to offset some of these losses: wash trading.

The Internal Revenue Service’s wash-sale rule prohibits investors for claiming losses on securities sold at a loss and reacquired within 30 days — preventing taxpayers from using “artificial” losses to offset their gains and lower their capital gains tax liability.

While there is a chance that the wash-sale rule will apply to the crypto industry in the future, for now, it doesn’t — and loss harvesting through this tactic is possible for investors.

Crypto Not Considered an Equity

Indeed, the IRS says that for federal tax purposes virtual currency is treated as property.

“General tax principles applicable to property transactions apply to transactions using virtual currency,” according to the IRS. As such, crypto is not subject to equities rules.

“Until regulations catch up, wash-sale rules don’t currently apply to crypto,” said Nick Reilly, part of the expert community with social crypto platform and marketplace Earnity. “Therefore, due to the recent bear market we’ve experienced in the space, many investors have the opportunity to realize positions they may have losses in and use them to offset current — and future — capital gains.”

Reilly explained the steps: First, sell positions that you have a loss in, which “realizes” the loss for tax purposes.

Investing for Everyone

“You may do what you want with the proceeds, such as buy back the same token or invest in something different,” he said. “Document the transaction accurately, for when you originally bought the token and eventually sold it. Then report the losses — and potential gains — using tax form 8949. Note: This step can be done using crypto tax software.”

To put things in context, as of Dec. 19, the global crypto market cap stood at $807.81 billion — a far cry from the $3 trillion it had reached in November 2021, according to CoinMarketCap data. Bitcoin — the largest crypto by market cap — hovered around $17,700 on Dec. 19, down a brutal 74.3% from its November 2021 all-time-high of $68,790.

The wash-sale strategy is a unique trait to crypto markets and presents a silver lining during difficult markets, said Jackson Wood, portfolio manager at Freedom Day Solutions and a community expert at Earnity.

“The losses realized in crypto can also be used to offset gains in other asset classes like real estate, stock market investing, etc.,” Wood said. “Savvy investors need to understand this unique opportunity. When used appropriately, [it] can be a beneficial tactic in portfolio and asset management.”

Regulation Wanted by Some

While this is indeed a silver lining for investors, some experts believe it reflects the lack of regularity clarity for the space — something many are pushing for to avoid future debacles.

“Unfortunately, many crypto-related parties use wash trading as a popular way to harvest their tax losses. Until the law changes, there is no reason to come down on this form of tax-loss harvesting,” said Bob Ras, co-founder of Sologenic. “That said, if there were more regulatory clarity, then perhaps wash trading would become more in line with what the rules are with equities. But until then, sadly, it seems it’s legal so that people will do it. The sooner crypto’s Wild West days end, the sooner the industry will mature and grow.”

Investing for Everyone

In addition, wash trading applies to NFTs, said Ganesh Swami, co-founder and CEO of Covalent, adding that “it’s not a great aspect of our industry.”

“But if we had clearer regulations for the industry and better data coverage, then wash trading would not be a problem,” Swami said. “In the end, it’s legal, so what would you expect? Tradfi [traditional finance] equity traders would do the same if it wasn’t so easy to be discovered. So of course it will happen in crypto — it’s within the law, it’s easy to cover your tracks, and tax softwares make wash trading super efficient because it’s highly accurate.”

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