Tax-Loss Harvesting with Cryptocurrencies

Abstract

We describe the landscape of taxation in the crypto markets, especially that concerning U.S. taxpayers, and examine how recent increases in tax scrutiny have led to changes in trading behavior by crypto traders. We predict under a simple conceptual framework and then empirically document 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 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 also discuss new gray areas for tax regulation relating to new crypto assets such as Non-Fungible Tokens and Decentralized Finance protocols that further highlight the importance of coordinating tax policy and other regulations.

Keywords: Bitcoin, Cryptocurrencies, DeFi, IRS, NFT, Regulation, Taxation, Trading Behavior.

JEL Classification: G15, G18, G29, K29, K42, O16.