Because the Wash Sale section of the Internal Revenue Code does not mention ‘digital assets,’ the IRS cannot automatically disallow a loss when the same asset is purchased within 30 days. Still, taxpayers must follow other loss rules, which require the transaction to be complete and the loss to be genuine.
Due to an oversight, several of your favorite tokens were liquidated by a DeFi protocol to maintain a margin requirement. Although you sustained a loss on the margin call, you believe in the token’s long-term growth and quickly reacquire the tokens. Are you at risk of the IRS automatically disallowing the loss under the existing wash sale rules? Probably not.
By its terms, section 1091 (wash sales) applies only to shares of stock or securities. A wash sale describes a situation where a taxpayer acquires substantially identical stock or securities in a 60-day window centered around the date of the loss transaction. Despite policy arguments that support treating tokens as securities for applying wash-sale loss disallowance rules, in recent years the Tax Court has trended strongly toward ‘textualism.’ That is, if the words are not in the statute, the Tax Court is not going to fill any holes, even if it would be good tax policy. In a 2022 decision, the Tax Court chided the IRS for spending little time with the statutory text and called the IRS’ reliance on policy as “a relic from a bygone era of statutory construction.” Whistleblower 972-17W v. Commissioner, 159 T.C. 1. So, until section 1091 is amended, there is little risk that existing wash sale rules will be applied to digital assets.
Does this mean that taxpayers who are bullish on a single token are free to engage in wash sales to harvest their losses and save them to offset future gains? Like the above question, the answer is ‘probably not.’
Even if the wash sale rules do not apply, all taxpayers are subject to the ‘economic substance’ and ‘business purpose’ test for their activities. The regulations under section 165, which governs losses, explicitly state that ‘only a bona fide loss is allowable. Substance and not mere form shall govern in determining a deductible loss.’ A circular transaction that puts the taxpayer in the same position with respect to a token with the only change being a tax loss could be challenged by the IRS as not being a bona fide loss. Would the margin call described above be challenged by the IRS in a similar manner? That is not as clear, since the assets were being used to secure other trading activity and the sale was not initiated directly by the taxpayer.
Every situation is unique, and RSM US Tax Advisors can assist you with your potential wash- sale loss questions.
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