Photo by Maxim Hopman on Unsplash

Crypto has had a wild ride lately. Over the last six months, Bitcoin plummeted by nearly half, erasing billions of dollars of market value. Many sophisticated crypto investors, though, likely don’t care at all. Why? These crypto whales use a special kind of financial alchemy to achieve massive profits even if the crypto markets tank. And they do it all without paying taxes. It’s totally legal (for now anyway), and is driven by a loophole that’s hiding in plain sight.

To understand how their process works, we need to look at Defi, tax policy, and the weird dynamics that drive crypto markets.

Selling Coca Cola

Imagine that an investor buys a traditional stock, like Coca-Cola. The company then has a bad quarter, and its share price goes down. Our investor sells her shares at a loss. On her taxes, our investor can then take a deduction for her capital loss. (Just a reminder — this article isn’t intended to provide tax or investment advice, and you should consult a professional advisor for advice on your own tax and investment situation.)

Basically, she can use her investing loss on Coca-Cola stock to offset any investment gains she’s made elsewhere in her portfolio or even some of the income she earned from her job. Allowing deductions for capital losses is a way that the IRS eases the blow of financial losses for investors.

What our investor can’t do, though, is buy Coca-Cola, sell it at a loss, claim the loss on her taxes, and then immediately buy Coca-Cola stock again. That’s called a “wash sale,” and it’s against the rules. For most traditional securities, investors need to wait 30 days after selling shares before they can buy them again, or they risk losing their tax deduction.

The wash sale rule makes sense. Without it, investors would be constantly selling their stocks and buying them again, eking out tax deductions when the market dropped without really exiting their investment. Sure, they’d part with their Coca-Cola stock for a few minutes each time the market went down. But they’d immediately buy those same shares back, so it would be like they never parted with them at all.

The IRS doesn’t like that kind of behavior — thus, we have the wash sale rule.

Washing Your Bitcoins

Here’s the thing, though. The wash sale rule only applies to financial securities. And since a fateful 2014 decision, the IRS has considered virtual currencies property, not financial securities or actual currency. That means they’re treated more like a boat or a bar of gold than a stock or bond.

One other thing the “property” designation buys: Unlike financial instruments, cryptocurrencies generally aren’t subject to the wash sale rule in the United States. That means investors can cheerfully sell them, claim a loss on their taxes, and buy the same coins immediately with no issues from the government. For sophisticated crypto investors, that’s a huge deal.

Let’s imagine that our theoretical investor buys $1 million of Bitcoin. The price drops by half, and her Bitcoins are now worth $500,000. She sells them — locking in a $500,000 tax loss — and immediately buys them again. In 9 months, the coin’s price comes roaring back, and her Bitcoins are now worth $1,100,000. Given Bitcoin’s swings in 2020 alone, that’s a totally reasonable scenario.

Our investor is up by $100,000. But because of her wash sale, she still gets to claim a $500,000 capital loss on her taxes. Again, she can use that loss to offset gains in another part of her portfolio or carry some of it forward to future years. Assuming she’s in the top tax bracket (she has $1 million to invest into Bitcoin, after all), she can avoid the 20% capital gains tax on that $500,000, effectively saving herself $100,000 in taxes. And that’s on top of the $100,000 she made from her coins appreciating in value.

Basically, she can have her cake and eat it too — achieving big investment gains, while still claiming a massive loss on her taxes.

On the Upside

There’s a catch though, right? When our investor sold and rebought her coins for $500,000, she reset her cost basis. If her Bitcoins are now worth $1,100,000 and she sells them, she’ll still need to pay taxes on the full $600,000 that they gained since she did her wash sale. That should offset the tax benefits of the wash sale, right?

Only if she actually sells her coins. Instead of parting with their coins, many big crypto investors choose to hold them forever. When they need access to cash, they take out loans using their crypto holdings as collateral. Since they never actually sell their coins, they never pay taxes on those coins’ gains.

Coinbase, a major crypto exchange, even advertises this as a major feature of their platform. They’ll lend you up to $1 million in actual dollars, using your crypto holdings to back up your loan. In their words, “selling Bitcoin can result in a taxable gain or loss,” and their platform lets people “borrow from Coinbase to get cash without selling your Bitcoin,” presumably to avoid these taxable events. Other platforms, like Figure, will even extend you a mortgage based on your crypto holdings.

Our investor could borrow up to $440,000 from a platform like Coinbase without selling a cent’s worth of her Bitcoin, and without incurring any taxes at all on her gains — all while keeping her $500,000 tax loss due to the wash sale rule. If she didn’t want to take out a loan, our investor could also lend her Bitcoins to others using a Defi platform like Cake, receiving daily cash interest on her coins without selling them and triggering taxes on her gains.

Volatility is Good

The unique tax treatment of cryptocurrencies — as well as the growth of Defi and crypto lending — explain why sophisticated crypto investors couldn’t care less whether the crypto market tanks.

If the markets go down, they’ll do a wash sale, take a massive loss, save a bundle on their taxes, and wait until the market recovers. When their coins do gain in value, they’ll get all the cash they need (and still avoid taxes) by lending out their coins or using them as collateral for a cash loan instead of selling them.

In fact, sophisticated crypto investors may even want the market to tank periodically, as long as it eventually recovers. Massive short-term drops give them a chance to perform a wash sale and lock in tax losses, offsetting either their future crypto gains or gains from other parts of their portfolios. If their crypto holdings appreciate in value, they’re probably still happy. But a massive loss followed by a big recovery is actually better for them financially than having crypto prices go up consistently over time.

Caveats, and Plugging the Loophole

Of course, there are some caveats. This strategy only works for US-based crypto investors — countries like the UK already have rules against crypto wash sales. Our investor also needs to be confident that her coins will increase in value over the long term, even if they drop in value occasionally. Otherwise, she’ll never be able to recover the actual losses she incurs when the market tanks. As the Luna disaster shows, this is not always a given.

For our investor to use her $500,000 loss effectively, she also needs to incur capital gains elsewhere in her portfolio. These could be from other crypto holdings, or from selling other stocks, bonds, or property that has increased in value. In short, this strategy would work best for a big investor who has a lot of investing-related gains that she wants to shelter from taxes.

There’s also the obvious point that this loophole isn’t exactly fair. Investors in traditional securities like stocks and bonds can’t take advantage of the wash sale loophole. That puts cryptocurrencies at an advantage versus equities and other more traditional investments. To the extent that big investors encourage volatility in order to create the opportunity for wash sales, the loophole also isn’t fair to small crypto investors, who can see their life savings wiped out if crypto prices drop.

The US government has taken notice, and is thus actively working to close the crypto wash sale loophole. Joe Biden’s Build Back Better bill includes a provision to get rid of the wash sale loophole for crypto. But that bill is stalled by partisan bickering, and unlikely to pass any time soon. That means many big crypto investors are likely still making a killing from the wash sale rule, especially with crypto’s recent volatility.

Close the Loophole, Kill the Market?

What would closing the loophole do for crypto markets? For one thing, it might make cryptocurrencies less volatile. Again, right now crypto investors enjoy a degree of antifragility, in that they actually gain from volatility in crypto markets. Eliminate those gains, and the incentive for volatile markets goes away with it. Crypto will likely always be volatile, but it might become less so.

There’s also the chance, though, that lots of big investors are investing in cryptocurrencies because of their uniquely strange tax treatment. They might not believe in the coins at all, but may see a great tax deal and want to snap it up. With the wash sale rule gone, they could readily move their money into another type of investment, driving crypto prices down. Ditto if efforts succeed to tax unrealized gains, which would eliminate the tax benefits of borrowing against the value of cryptocurrencies instead of selling them.

Until the loophole closes, we really won’t know. For now, sophisticated crypto investors will probably go right on investing in the cryptocurrencies — and laughing all the way to the bank when crypto markets go down.

This article is for informational purposes only and should not be construed as investment, tax or legal advice. Always consult a professional advisor for advice specific to your situation before making any major financial decisions, and never invest more than you can afford to lose. Thomas Smith holds a diversified investment portfolio that includes a variety of securities and cryptocurrencies.