Last Updated: September 25, 2020
If you are a cryptocurrency “trader” in the eyes of the IRS, you may be able to greatly benefit from a frequently overlooked tax election called the “475(f) election.”
Who Qualifies As A “Trader”?
The definition of a “trader” for tax purposes is different from the colloquial meaning of the term.
The IRS has published criteria on who qualifies as a trader. In layman's terms, if trading cryptocurrency is your full-time job and you carry out a substantial amount of trading continuously throughout the year with regularity, you could be qualified as a trader. Being a “Trader” enables you to bypass the default limit on capital loss deduction ($3,000 maximum a year) from cryptocurrency and activate a very powerful tax saving election called section 475(f).
If you are a trader, your default taxation is similar to a hobbyist cryptocurrency investor. Your profits are taxed as capital gains; losses are subject to the general capital loss limitations.
The main downside of the default tax rule is that, in any given year, the maximum net capital loss that can be claimed by an investor is capped at $3,000 (excess losses can be carried forward indefinitely to future years). For example, let's say you had a bad year with $90,000 worth of net losses. All else being equal, it would take 30 years ($90,000/$3,000) for you to totally write off this loss under the default tax method.
Activate 475(f) Election
The good news is that the 475(f) election allows traders to deduct crypto trading losses without being subject to the $3,000 annual limit. In the example above, if you are a trader who successfully made the 475(f) election, you would be able to write off $90,000 of losses in the year you incurred them, without being subject to any cap. Further, once you properly make this election, you can also write off unrealized losses (mark-to-market accounting) at year end leading to additional potential tax savings.
Note: with the 475(f) election, your gains on cryptocurrency held over 12 months (long term) will be taxed at a relatively higher ordinary income tax rate compared to the long term capital gain tax rates that casual investors pay. Moreover, If there are any unrealized gains at year end, you will also have to pay taxes on them (unlike casual investors).
Overall, if you are a true trader, you are more likely to benefit from this election.
How To Make The Election
There are many nuances associated with this election so 475(f) is an election you should make after carefully reviewing your tax profile with a qualified tax consultant. A properly drafted election statement as described in Rev. Proc 99-17, must be sent to the IRS within 75 days from the start of the year to which you want to apply this election.
The applicability of 475(f) tax election has been a hotly debated topic in the tax world. This is because the way the law is written, it is currently applicable only if you deal with “securities” and “commodities.” Since cryptocurrencies are taxed as “property” per IRS Notice 2014-21, the applicability of this election for crypto traders is a grey area. With that said, bitcoin and some crypto derivatives are treated as “commodities” by the CFTC so 475(f) election for those instruments is much clearer than other instruments. The AICPA has advocated the IRS to make this election applicable to crypto traders and other parties have asked for more clarity on this issue.
Disclaimer: this post is informational only and is not intended as tax or investment advice. For tax or investment advice, please consult a professional.