Congress Should Extend Wash Sale Rules to Digital Assets

By Taylor Cranor and Michael Kaercher

The Biden Administration’s 2024 Greenbook includes a proposal to ensure that digital assets are subject to the same “wash sale” rules as stocks and other assets. Investors can currently use wash sales to harvest losses on digital assets without changing their investment portfolio. Under the Greenbook proposal, investors would be unable to take deductions for losses on their digital assets unless they sold the assets. Extending the wash sale rules to digital assets is a sound policy that would prohibit an aggressive tax planning practice, improve equity between investors in digital assets and investors in other types of assets, and raise significant revenue.

The value of many digital assets, including cryptocurrencies, fell precipitously in 2022. Digital asset owners who engaged in tax-motivated “wash sale” transactions at the end of 2022 are taking advantage of this decline in asset value during the ongoing filing season. Wash sales allow taxpayers to reduce their tax liability without making any meaningful changes to their investment portfolio.

Long-standing rules prevent taxpayers from engaging in wash sales to harvest losses on stocks and securities. However, lawmakers have not modified the wash sale section of the Internal Revenue Code (the “Code”) since before Satoshi Nakamoto’s original Bitcoin white paper was released in 2008, and current guidance does not generally treat digital assets as securities. As a result digital asset investors can benefit from wash sales, while investors in stocks and securities cannot. This creates a distortion, effectively a tax subsidy for investment in digital assets over stock and securities.

The Biden Administration’s 2024 Greenbook includes a proposal to prohibit digital asset owners from realizing tax benefits from wash sales, just as the Code already does for owners of other types of assets. The proposal would prohibit an aggressive tax planning practice, treat digital asset investors the same as other investors, and raise revenue.

Background

Generally, the Code only taxes investment gains or allows deductions for investment losses when a taxpayer sells their investment. If A buys a stock for $100 and the value of that stock is $200 a year later, A is not taxed on that gain until they sell the stock. The Code mirrors this treatment for losses: if A buys the stock for $100 but instead the value of that stock falls to $25 a year later, A also cannot deduct that loss in value unless they sell the stock.

The wash sale rules prevent investors from engaging in practices that undermine the Code’s current approach to gains and losses. Under section 1091, if a taxpayer sells a stock or security for a loss and purchases the same or a substantially identical stock or security within 30 days before or after the sale (a “wash sale”), they cannot immediately deduct the loss. The wash sale rules disallow the loss and provide that the taxpayer take a modified carryover basis in the new stock or security, deferring the loss until the taxpayer sells the new asset. The reasoning behind section 1091 is that the taxpayer has not “locked in” a loss because they remain invested in a substantially identical stock or security, which could still change in value. Therefore, the taxpayer should not be able to deduct the loss currently.

Without the wash sale rules in place, a taxpayer could not only indefinitely delay (or avoid entirely) taxes on the gains on their stocks or securities by simply not selling the assets, but also immediately deduct losses. (There are broader proposals to align the tax treatment of both gains and losses to when they occur economically, and also to address other transactions that avoid wash sale rules, but this is not the subject of this proposal or discussion.)

Digital Assets Escape The Wash Sale Rules

A gap in section 1091 allows digital asset investors to ignore the wash sale rules. Section 1091 only applies to “shares of stock or securities.” The IRS generally does not treat digital assets as stocks or securities. As a result, the wash sale rules do not apply to digital assets. If a taxpayer sells cryptocurrency for a loss and immediately repurchases the same cryptocurrency, they can deduct the loss from their income even though their investment remains substantially the same.

Empirical research shows that digital asset investors take advantage of the gap in the wash sale rules to harvest their losses: a recent study found that wash sales “dominate[] [US] traders’ activities around year-ends and during market downturns.”

The gap in the wash sale rules for digital assets undermines horizontal equity, the principle that taxpayers in the same economic situation should face the same tax consequences. An investor in a digital asset that falls in value can access a tax deduction for it by engaging in a wash sale when an investor in stocks could not.

Access to wash sales amounts to an unintended tax subsidy for investments in digital assets over other types of assets. Economists call this a “tax expenditure,” because although this subsidy is delivered through the tax system, the loss of revenue would have the same impact on the budget as if the government wrote digital asset investors a check. Evaluating whether a tax expenditure is bad or good policy requires considering the fiscal cost and the desirability of creating a tax incentive for resources to flow towards the subsidized activity and away from others. It is far from clear that investment in digital assets should be subsidized by the federal government, given the risks digital assets pose for consumers, investors, and others.

The gap in the wash sale rules also reduces tax revenues by allowing investors in digital assets to reduce their tax liability by immediately taking deductions for losses even when they remain invested in the same assets.

Applying wash sale rules to digital assets would increase equity and revenues

The Biden Administration’s proposal would add digital assets to the list of assets subject to the wash sale rules, an approach very similar to that in the House-passed version of the Build Back Better Act. This would ensure that investors in digital assets cannot access an aggressive tax planning technique that is already prohibited for other types of assets, improving horizontal equity and removing a tax subsidy for digital assets. Treasury estimates that extending the wash sale rules to digital assets, along with other changes, including addressing related party transactions in the wash sale rules, would raise $23.5 billion over 10 years.

(Treasury noted that its Greenbook proposals “are not intended to create any inferences regarding current law,” meaning its proposals do not foreclose regulatory routes. In this blog, we focus on assessing the implications of the statutory proposal rather than examining whether Treasury can and should write guidance treating certain digital assets as securities for the purposes of the wash sale rules.)

The proposal would likely most affect high-income filers. Selling an asset like cryptocurrency or stock for more or less than the purchase price typically results in a capital gain or loss (respectively) for an individual taxpayer. A taxpayer can offset their capital gains with their capital losses to the full extent of their capital losses. However, if a taxpayer has ordinary income, such as earnings from a job, and insufficient capital gains to offset, they can only offset their ordinary income with up to $3,000 of capital losses. As a result, the gap in the wash sale rules for digital assets is most valuable to taxpayers with significant realized capital gains to offset. There are not good data on the characteristics of filers realizing digital asset losses specifically, but realized capital gains generally are disproportionately concentrated among high-income filers.

Extending the wash sale rules to digital assets should not be used to pay for new inefficient tax subsidies for digital assets.

Some congressional lawmakers have proposed using revenues from extending the wash sale rules to digital assets to pay for a broader package of digital asset proposals in the Responsible Financial Innovation Act (RFIA), a bill that includes new tax subsidies for digital assets.

The wash sale proposal is good policy, as explained here, and lawmakers should push forward legislation to enact it. However, it would be unwise to use the associated revenue to pay for other inappropriate tax preferences for digital assets. The RFIA would defer income from mining and staking, exclude from gross income a certain amount of gain or loss on personal transactions using virtual currency, and narrow the broker reporting regime, among other changes to the taxation and regulation of digital assets.

We explain in a prior report that tax subsidies for digital assets, including those proposed in RFIA, are unsound and would create distortions, shifting resources towards digital assets and away from other investments and activities. Eliminating one tax subsidy for digital assets should not give rise to new ones.

Conclusion

The marketwide decline in digital asset values in 2022 gave many investors the opportunity to exploit the gap in the wash sale rules to lower their tax liability this filing season, underlining the importance of applying the wash sale rules to digital assets. The Biden Administration’s Greenbook proposal would extend the wash sale rules to digital assets, improving horizontal equity between investors, reducing aggressive tax planning, and generating substantial revenue. Lawmakers should pass legislation based on this proposal to close the gap in the wash sale rules — but should not do so in order to pay for new inefficient tax subsidies for digital assets.

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