Tax-Loss Harvesting with Cryptocurrencies

Abstract

This study describes the landscape of taxation in the crypto markets concerning U.S. taxpayers, and examines how recent increases in tax scrutiny have lead to changes in trading behavior by crypto traders. Using a conceptual framework, we predict and find that increased tax scrutiny leads crypto investors to utilize legal tax planning with tax-loss harvesting as an alternative to non-compliance. In particular, domestic traders increase compliance and tax-loss harvesting following the increase in tax scrutiny, and U.S. exchanges exhibit a significantly greater amount of wash trading. Additional findings suggest that broad-based and targeted changes in tax scrutiny can differentially affect crypto traders’ preference for U.S.-based exchanges. We discuss new gray areas for tax regulation relating to new crypto assets such as Non-Fungible Tokens and Decentralized Finance protocols that highlight the importance of the coordination between tax policy and other regulations.