From its inception, cryptocurrency has been a complicated and somewhat contentious asset. Is it a currency? Is it a long-term investment? Is it the inflation hedge proponents originally claimed it to be? Whatever your opinion on the topic, crypto is polarizing, creating cynics and fanatics alike. In 2014, however, the IRS ruled that virtual currency be treated as property for federal income tax purposes, not currency. This makes sense based on how these assets are being used today. A 2021 Federal Reserve study found that just 3% of Americans used crypto to make purchases or money transfers.
In other words, selling crypto will result in capital gain treatment. The same can be said for incurring a loss at the time of sale, which has become a point of concern due to today’s market volatility — made even worse by recent events involving cryptocurrency: the collapse and subsequent criminal charges against FTX and its founder, the bankruptcy of cryptocurrency exchange BlockFi, the class action lawsuit against Gemini, and so on.
The down market notwithstanding — though it seems that things are starting to look up in the crypto world — investors are beginning to realize the lack of regulatory industry oversight and its impact on asset prices. This has naturally led to questions such as: “How much crypto should I have in my portfolio? Should I have any at all?”
Unfortunately, the answers aren’t as cut and dried as most investors would like. They really depend on your investment goals, risk tolerance, and other portfolio assets. Though already a volatile asset class in its infancy, crypto and a recession — or at least the potential of one — haven’t made for good bedfellows. Bitcoin and Ethereum, for example, have been down more than 57% so far this year. Although long-term returns have been strong historically, it’s unlikely that most new investors in the space have the stomach or risk tolerance to weather such unpredictability.
Weathering the Potential Recession and Cryptocurrency Storm
For those who’ve already invested in cryptocurrency, there are a couple of things to keep in mind going forward. First and foremost, it could have an impact on your taxes. If you held this asset class at an online exchange and sold it during the year, you’ll likely receive a 1099 form to report a gain or loss because a taxable event occurred. Converting one cryptocurrency to another cryptocurrency would fall under this same category, as would using it to pay for goods or services. If the crypto was held for more than a year, then you pay the more favorable capital gains tax rate on any gains.
Cryptocurrency and estate planning are other facets to be aware of. Estate planning can be trickier than if you held a bitcoin mutual fund in a brokerage account. Larger exchanges are often able to add beneficiary designations. BlockFi, for instance, allows you to open an account in a trust’s name and add a beneficiary designation to non-trust accounts. Such an option allows for several benefits when it comes to your estate plan.
For those who hold cryptocurrency in hot/cold wallets outside of an exchange, an experienced estate planning attorney can help create the necessary documents or incorporate language into the existing trust that documents crypto assets. This can help you avoid issues around the probate process and make sure your heirs are aware of these assets.
Once you’ve arrived at a decision around cryptocurrency and estate planning, as well as the tax implications involved with selling this asset class, your attention should turn to how to position a crypto portfolio in a down market.
Falling Values: How to Position a Crypto Portfolio in a Down Market
Positioning a crypto portfolio in a down market can be a bit of a minefield for a novice. It’s not like a purchase comes with instructions. The onus is on you to determine the best move to reach your investment goals. However, there are a few things you should keep in mind:
1. Talk to an advisor about an asset allocation plan.
An asset allocation plan is all about balancing risk and return. Sounds simple enough. Without expert advice, however, it can be difficult to set the right targeted mix of asset classes (i.e., stocks, bonds, cash, crypto, etc.) that align with both your investment objectives and budget constraints. Work with an advisor to determine whether adding other asset classes is the best strategy for positioning your crypto portfolio in a down market. Review the weight of each asset class periodically, and then rebalance when you’ve strayed too far from the target.
2. Evaluate your risk tolerance.
Understanding your personality and how you’ll realistically react in a time of prolonged negative performance is important to managing crypto holdings. In fact, times of market volatility are ideal to ask yourself questions such as, “How much crypto should I have in my portfolio? Should I rebalance to add more funds to my loss position? Or, should I revisit the risk I am comfortable with and use this as a time to strategically exit the position?” Just don’t make any rash decisions or put yourself in a precarious financial situation.
3. Take advantage of tax loss harvesting in a bear market.
When a bear market and cryptocurrency meet, tax loss harvesting can help offset potential capital gain costs incurred by selling to rebalance your holdings. And because wash sale rules don’t apply to crypto (at least at the time of this article), you could sell a position at a loss, capture that capital loss to offset future gains, and reinvest the proceeds the next day.
It can be nerve-racking to hold cryptocurrency in a down market (or a volatile one, at that). Consult with an advisor, create an asset allocation plan, and take advantage of any tax strategies available regarding losses or gains. Always keep in mind that assets are unpredictable — bull or bear market.
Jacob Malina is a Wealth Manager at Plancorp. Plancorp provides comprehensive, holistic financial planning and investment advisory services for individuals, families, business owners, nonprofit, and institutional clients.