Crypto traders use tax loss harvesting to save billions, says research

Crypto traders use tax loss harvesting to save billions, says research

The market for cryptocurrencies and other crypto assets has grown from near zero in 2009 post-East Asian crisis to more than a trillion U.S. dollars of market capitalization in 2022. The rise and innovation of digital assets and decentralized finance (DeFi), along with their volatile markets, have created a growing need for regulatory oversight of financial stability, investor protection, national security, etc.

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 crypto assets. Especially concerning is the high level of noncompliance with reporting income from crypto activities, lack of transparency for tax authorities into the crypto markets, and uncertainty about how to apply tax rules to crypto activities.

As per a research paper published by the National Bureau of Economic Research, USA, crypto traders are avoiding billions of dollars in tax by taking advantage of wide price swings to Harvest losses so they can be offset against other profits.

Crypto tax-loss harvesting involves realizing crypto losses to offset your capital gains, thereby lowering the tax burden. Investors typically tax harvest near the end of the year when they can approximate their total gains, or during market dips when losses are highest. The same strategy used in tax-loss harvesting crypto applies to digital currency gains or other assets, such as year-end mutual fund payouts.

The researchers analyzed two data sources; the first dataset comprises proprietary full-detailed account-level trading reports for 500 large retail traders (“trading account” dataset). The second dataset is trade-by-trade information extracted from the trading books of thirty-four major crypto exchanges, comprising billions of trades (“exchange” dataset).

According to the paper, the data include the trading activities in the form of trading reports for the tax firm’s 500 largest retail traders. Approximately one-fourth of the traders are U.S.-based taxpayers, and the remaining traders are internationally domiciled. The data include information on inbound and outbound transfers, cryptocurrency pairs, fees collected, transaction size, prices in Bitcoins and U.S. dollars, and the crypto exchange used for each transaction.

The results mentioned that an increase in tax scrutiny led to an increase in the tax-loss harvesting by crypto traders as they become more tax compliant and increase their tax planning. However,
the findings do not rule out the possibility that traders also adopt strategies to reduce reported income by moving their trades to non-U.S. exchanges or to markets in new innovative virtual asset
classes for which their tax treatment is to a date uncertain. Moreover, the tax authorities are not
working in isolation—other regulators such as the Securities and Exchange Commission (SEC)
are introducing changes that interact with taxation.

Further, during periods of increased tax scrutiny, net exchange activity is significantly larger for the U.S.
exchanges, i.e., those that have a presence or are regulated in the United States. The result also estimated the size of Revenue loss from the Tax loss harvesting.

The paper also discussed new grey areas for tax regulation relating to new crypto assets such as Non-Fungible Tokens (NFTs) and Decentralized Finance (DeFi) protocols and concluded that transactions in NFTs as well as the lending rate in DeFi lending peak toward year-ends, which is consistent with the seasonality of tax considerations. These findings suggest that crypto investors are likely to make endogenous changes in tax planning strategies in response to changes in tax rules including investing in new crypto assets that create challenges for policymakers to predict the effects of tax policy changes. Collectively, the result highlights the importance of coordinating tax policy
and other regulations.

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

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