Crypto traders avoiding billions in tax by 'loss harvesting'

Crypto traders are avoiding billions of dollars in tax by taking advantage of wild price swings to "harvest" losses so they can be offset against other profits, according to a paper published by the National Bureau of Economic Research.

The analysis, based on a dataset of 500 large retail traders and billions of transactions on 34 crypto exchanges, found that the largely unregulated asset class is becoming a mainstay for tax avoidance.

Had the scale of "tax-loss harvesting" identified by the researchers been used by traders in 2018, when Bitcoin crashed by 30%, it would have cost the U.S. Treasury as much as $16 billion, they estimated.

Moe Zoyari/Photographer: Moe Zoyari/Bloombe

Crypto trading has exploded since it emerged in 2009. The market was worth more than $1 trillion in the first half of 2022, and almost a third of Americans aged 18-29 claim to have invested, traded or used a cryptocurrency.

Regulators are struggling to keep up. Traders have been avoiding as much as $50 billion of taxes a year by not declaring their gains, Barclays Plc managing director Joseph Abate estimated last year.

The Internal Revenue Service has begun to crack down by requiring brokers to report crypto transactions worth at least $10,000 from later this year. However, the increased scrutiny is changing behavior. Some traders are simply switching from illegal evasion to legal avoidance, the NBER paper found. 

Instead of hiding gains, traders avoid tax by declaring losses using "wash trades" that are barred in regulated securities markets. Wash trades are sales that crystallize losses before the assets are bought back almost immediately. Crystallizing losses to offset other profits and reduce the overall tax bill is known as "tax loss harvesting."

In securities markets, the strategy is not allowed if the same asset is bought 30 days before or after the sale. "The need for oversight and policy clarity on crypto taxation is among the most pressing because existing tax laws and regulations were not designed to deal with the rise of cryptoassets," the NBER paper's authors said.

Their analysis found that after the IRS began to step up its scrutiny, tax loss harvesting was 8% higher among domestic U.S. traders at critical periods, such as year-ends or market downturns, than international peers.

The authors also warned that greater scrutiny might encourage people to move trades to non-U.S. exchanges. They said U.S. regulators will need to coordinate internationally to stop the activity — and what tax can be collected — simply moving overseas.