The realm of digital assets is notably complex. Utilizing blockchain technologies and available for global exchange around the clock, these markets are characterized by rapid shifts and a wealth of information. A methodical investment strategy seems particularly fitting for navigating this environment.
Implementing a systematic approach can also reveal a significant advantage for diversified cryptocurrency portfolios: the ability to automate tax-loss harvesting.
What is tax-loss harvesting (TLH)?
Investors typically acquire assets anticipating growth over time. However, market fluctuations mean that losses are inevitable. At times, investors find themselves holding assets below their acquisition price.
When assets are held at a loss, investors have the option to sell them, thereby realizing a loss that can offset any realized gains or regular income. During this process, the proceeds from the sale of the depreciated assets can be reinvested into similar instruments (for example, selling shares of Home Depot and purchasing shares of Lowe’s), which helps to sustain overall portfolio exposure.
The result? Investors end up with a smaller tax bill each year while preserving their investment exposure. This deferral of tax liabilities allows for a greater amount to remain invested, potentially leading to more substantial growth over the long term.
Why automate?
Software and algorithms are more adept at systematically identifying and capitalizing on TLH opportunities than manual methods. To effectively harvest losses, investors must monitor their cost basis and purchase dates, along with executing trades across their entire portfolio—tasks that are far better suited to a mechanical process, particularly when dealing with multi-asset portfolios comprising numerous digital assets.
When does TLH function optimally?
TLH serves as a systematic strategy that enables investors to maximize their portfolio’s performance. Large, well-diversified liquid portfolios are particularly favorable for this technique since they allow for straightforward trades and the replacement of assets with similar ones (for instance, swapping Coca-Cola shares with Pepsi shares).
The same is applicable in cryptocurrency markets; portfolios with many digital assets typically offer greater flexibility for TLH than those consisting of one or two assets.
In fact, this tax-efficient investment approach may prove especially advantageous for cryptocurrency assets, which tend to display higher volatility compared to traditional asset classes such as stocks and bonds. While this volatility might dissuade some investors, TLH offers a welcome benefit.
When isn’t TLH effective?
Since TLH involves re-establishing the cost basis through the sale and replacement of specific assets, not all investment options are conducive to this strategy:
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Exchange-traded funds (ETFs): An ETF counts as a single holding. For example, if an investor buys an S&P 500 ETF, that position will show either a loss or not, with limited options for trading the underlying stocks. However, if an investor purchases all 500 stocks in the S&P 500 individually, they can initiate a TLH strategy by selling certain assets and replacing them with others. This limitation is a significant disadvantage for existing cryptocurrency ETFs, which often consist mainly of single assets and lack diversification.
- Single-asset investments (e.g., solely BTC or ETH) or a limited number of holdings (e.g., just 2-3 assets): In traditional markets, TLH is not applicable to single-asset holdings due to the absence of a “replacement” asset. The wash rule restricts investors in traditional finance settings from selling and repurchasing the same asset solely for claiming a loss to secure a tax deduction. However, the wash rule does not currently apply to cryptocurrencies, which presents an opportunity for crypto investors to benefit from TLH even with minimal assets. However, this situation may not last indefinitely, primarily due to a lack of regulatory oversight rather than intentional policy.
How can investors begin?
Investors can access liquid, actively managed multi-asset portfolios that include numerous assets, facilitate automatic rebalancing, and execute automated TLH through direct-index crypto separately managed accounts (SMAs) managed by various crypto SMA providers.