Disclaimer: This article is intended as an informative piece. This is not accounting or tax advice. Please speak to a qualified tax professional about your specific circumstances before acting upon any of the information in this article.
Although this may seem nonsensical, the way cryptocurrencies are taxed combined with the volatility of crypto markets means this situation really has happened to some traders.
The key is that US tax years are calendar years, and tax is charged on the gains you realized during the year, not on what your portfolio is worth when the bill arrives. Here is how it usually plays out:
An investor buys 2 bitcoin at $20,000 each in early 2023, spending $40,000 in total.
In December 2024, with bitcoin at $100,000, they swap both coins for ether. Trading one cryptocurrency for another is a disposal, so this realizes a capital gain of $160,000 ($200,000 proceeds minus $40,000 cost basis).
Because they held the bitcoin for more than a year, the gain is long-term. Assume their other taxable income places the entire gain in the 20% long-term capital gains band: ignoring transaction fees, the Net Investment Income Tax and state tax, the federal tax on the gain is $32,000, due on their 2024 return and payable by April 2025. (Had they held for a year or less, the gain would be short-term and taxed at ordinary income rates of up to 37%.)
During 2025 the price of ether falls sharply. By the time the bill is due, their entire portfolio is worth $25,000, which is $7,000 less than the tax owed on the previous year's gains.
There is a silver lining. The investor now has a large unrealized loss on their ether. If they sell and realize that loss, it can offset gains in the current year, and up to $3,000 of net losses ($1,500 if married filing separately) can be claimed against ordinary income, with the rest carried forward. This strategy is called tax-loss harvesting, and we cover it in our article on using losses to offset taxable gains. We advise speaking to a qualified tax professional before acting on it, as claiming crypto losses can get complex.
This scenario is simplified, but similar ones really have occurred, especially in years where the market peaked late and fell early. If it happens to you, speak to a qualified tax professional promptly, file your return on time and pay as much as you can by the deadline. The IRS offers payment plans (installment agreements) for eligible taxpayers, although interest and penalties generally continue on the unpaid balance.
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