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KRAKOW, POLAND - 2018/12/25: Bitcoin stock market value is seen on a mobile phone. (Photo by Omar ... [+] Marques/SOPA Images/LightRocket via Getty Images)

The crypto market experienced one of its worst days in history with a nearly 50% one-day drop in the price of bitcoin. Economic uncertainties from the coronavirus pandemic and liquidity crunches have caused massive selloffs of bitcoin and other cryptocurrencies. Alt coins and DeFi platforms are experiencing similar issues as well. Not all hope is lost however. A downturn like this presents unique tax saving opportunities, especially in the cryptocurrency space. A brief lesson in the tax code could help you save thousands or more when you file your 2020 taxes.

It is extremely important to know that, claiming losses for tax purposes is different than having a loss in your portfolio. In most cases, the tax code only allows you to deduct realized losses.

It is likely that most of your cryptocurrency positions are in the red. For tax purposes, you can not deduct mere decrease in market value of your positions because they are unrealized. When you sell your position, these losses become realized and you can deduct the losses on your taxes.

For example, lets say David bought 1 bitcoin (BTC) at $10,000 on January 15, 2020. On March 11, 2020, the price of BTC drops to $3,000. In financial terms, he has lost $7,000 worth of value. However, from tax point of view, even though he has lost $7,000 worth of value, he has not realized this loss because he has not sold the position yet. If he were to keep this position without selling, he would NOT be able to deduct any losses for tax purposes despite having a financial loss.

Converting unrealized losses into realized losses allows David to get a deduction when he files his 2020 taxes. In order to realize his losses, he simply has to sell his positions that are at a loss. He also has an option to buy back into the same positions at a much lower price (without compromising the ability deduct losses) because wash sale rules are not applicable to cryptocurrencies under current guidance. Some crypto tax software helps you harvest tax losses.

Realizing some of your losses is super important to offset unexpected capital gains arising from margin liquidations. If you are a margin trader, it is likely that your initial margin has been liquidated due to large swings in prices. If you are trading on high leverage, even slight market fluctuations can trigger liquidations, and may result in capital gains taxes.

For example, assume Jennet deposited 1 BTC into her margin account on February 10, 2020, when the price of BTC was $9,000. She originally obtained this BTC in 2010 at a price of $1,000. She sets the leverage to be 5X so her notional buying power is 5 BTC (1 BTC x 5) or $45,000 ($9,000 x 5). Lets say Jennet goes long on ether with her full notional value of $45,000. At 5X leverage, if the $45,000 position goes down by 20% (notional value down to $36,000) her initial 1 BTC deposit will be liquidated by the exchange.

Assuming the BTC price is $9,000 at the time of the liquidation, she would end up having to pay taxes on $8,000 ($9,000 - $1,000) of capital gains. This is a tricky situation where Jennet actually owes capital gains taxes despite losing her investment.

Under the tax code, you can claim a maximum of $3,000 of capital losses on your tax return. However, the good news is that losses in excess of $3,000 can be carried forward indefinitely to future years. These losses can be used to offset future gains arising from crypto and stock transactions. To get advantage of this provision you need to realize your losses as explained above.

Knowing these simple tricks and executing them before the end of the year can help you get significant tax relief when you file for taxes. For the most part, the tax code only cares about your realized losses, not your real world loss in economic value. Use this to your advantage to reduce your taxes.

Disclaimer: this post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.

Excerpt from:
How To Make Money When The Cryptocurrency Market Is Tanking - Forbes