Crypto trading can be a painful process. The gains are good, but the losses can quickly stack up in such a volatile trading environment. However, there are ways you can reduce the effect of these losses, and that is where tax loss harvesting comes in.

Let's quickly delve into what crypto tax loss harvesting is, how it works, and its drawbacks.

What Is Crypto Tax Loss Harvesting?

Crypto tax loss harvesting is a strategy where you sell your crypto assets with a reduced value at a loss at the end of a tax year to reduce your tax burden. This approach helps you maximize your returns by reducing your tax liability.

How Does Crypto Tax Loss Harvesting Work?

When you profit from selling your crypto assets, they are subject to capital gains tax, meaning you must pay tax as required in your country. However, if you lose money on trades (or just overall!), you can use that to offset some of your profit and reduce the total amount you must pay as tax.

Let's say you buy a crypto worth $5,000 in the middle of the year, and by the end of the year, the value of the crypto has reduced to $3,000, which means that you have a 40% unrealized loss, amounting to $2,000. If you sell the crypto at a loss, you can use the $2,000 to offset other taxes you owe for that tax year or the next. You can use the capital losses you take from cryptocurrency to harvest taxes from cryptocurrencies and other assets, including stocks and real estate.

Some crypto tax laws allow you to carry over losses from one tax year to offset gains from the following tax year. You can do this if you experience a huge loss or one exceeding your gain in a tax year. For example, the United States Internal Revenue Service (IRS) allows crypto investors to carry over up to $3,000 of their capital losses to offset capital gains in future tax years.

Suppose you experience losses in cryptocurrency investments exceeding your current tax year gains. You can utilize the excess losses by carrying them forward to offset future capital gains. This way, you can reduce your tax liability and save money on taxes in the future.

To get the most out of crypto tax loss harvesting, you must record your investment activities and the results, that is, the profits and losses, to make it easy to calculate your taxable income and reduce errors and inconsistencies when reporting to a tax agency.

We will summarize how crypto tax loss harvesting works with the following steps so that you can understand it better.

1. Identify the cryptocurrency that has lost value. You can get this by comparing the price you paid for them with their current value.
2. Sell them to realize the loss. You must sell the asset before the tax year ends to claim the losses for the same year.
3. To decrease the tax liability on your capital gains, you must use the losses from selling those assets to offset the capital gains generated by other investments.
4. If the losses incurred from selling the unprofitable crypto assets outweigh your realized capital profit, you can extend the capital loss to offset the following year's profit. This is subject to specific limits as accepted by the tax regulations in your country or jurisdiction.

4 Disadvantages of Crypto Tax Loss Harvesting

Below are some of the drawbacks of crypto tax loss harvesting.

1. Market Volatility

Crypto market volatility can affect you in two ways when harvesting crypto tax loss. First, crypto prices fluctuate rapidly, making calculating your gains and losses difficult. The rapid price movement can lead to incorrect calculations, heightening the chances of making errors. Also, selling a crypto asset at a loss will make you miss out on any major price increase that may occur shortly after.

2. Complex Process

Crypto tax loss harvesting can be complicated, especially if you have to calculate the value of many cryptocurrencies or are unaware of your country's crypto investment tax implications. In addition, you may find it difficult to track the necessary records and calculate the figures as required.

If you can't calculate your crypto taxes yourself, you may need to seek the assistance of an expert or get reliable software that files taxes. Unfortunately, even though these options make it easy to calculate your taxes, they may also require you to pay some additional fees, reducing the overall benefit of the whole process.

3. Changing Cryptocurrency Regulations

Cryptocurrencies are still new, and the regulations are largely unclear and constantly changing. Therefore, you may need help to keep up with the latest tax laws in your country or jurisdiction.

4. Wash Sale Rule

Generally, wash sale rules disallow investors from claiming losses from the sale of an asset if they buy the same or an identical asset within 30 days before and after it is sold. Wash sale rules differ slightly from one country to another, and you may need to understand how the wash sale rule in your country works to know how best to carry out the tax loss harvesting process. These rules may affect the effectiveness of your crypto tax loss strategy.

You May Need to Consult Tax Professionals

Cryptocurrency regulations, including tax laws, differ from country to country. Different countries and jurisdictions have their own tax laws. For example, the IRS in the United States categorizes crypto as an asset like stocks and other capital assets. Furthermore, the amount gotten from crypto is taxed based on different conditions, like how long you held it, how you got it, and your tax bracket, among others.

Some countries don't even have clear guidelines regarding crypto taxation, and you may find it hard to understand how they work and the factors to consider when calculating them since they are not straightforward. For these reasons, you may need to get the service of a tax professional to handle tax-related issues effectively.