Crypto investors know that 2022 was a banner year in terms of failures and frauds in the crypto space. In our practice, we are often asked whether a taxpayer is entitled to deduct losses from such events. There is still a debate amongst tax professionals about the proper treatment of such events from a tax perspective, and such treatment varies depending on the facts of each specific case.
Today the IRS issued Chief Counsel Memorandum 202302011, which helps to clarify the proper treatment of crypto that has experienced a “substantial decline in value.” In the crypto space, this “substantial decline in value” generally applies to coins that have been rugged, but remain in the possession of the investor.
Specifically, CCM 202302011 discusses a taxpayer’s ability to deduct a loss under IRS §165, which deals with the deductibility of all manner of losses. Let’s look at a few of the more common arguments we hear from taxpayers and read about in articles posted online.
Generally, under §165 individual taxpayers can deduct losses from theft. This includes losses from scams such as Ponzi schemes, phishing attacks, and any other type of fraudulent activity that results in a loss of cryptocurrency.
Theft loss treatment applies in situations where coins have actually been stolen (i.e. the investor no longer has them in his or her possession), but not in a situation where an investor still holds crypto with little value. However, since the Tax Cuts and Jobs Act in 2017, these losses have been nondeductible unless they’re attributable to a federally declared disaster.
Capital loss recognition is triggered by a realization event (i.e. a sale or exchange). If there is no sale or exchange of the crypto asset in question, then capital loss treatment does not apply. So, in a situation where a crypto asset has declined in value, but not yet been disposed of by an investor, there has been no capital loss.
Abandonment losses are recognizable given three conditions:
- A transaction is entered into for profit
- A loss arises from the sudden termination of the usefulness of the asset, and
- The property is permanently discarded from use
If a taxpayer continues to hold devalued cryptocurrency, then that property has not been “permanently discarded” and there is no abandonment loss available.
A deduction for worthless securities is allowed if said security becomes completely worthless during a tax year. Generally, this loss is recognized as a capital loss occurring on the last day of the tax year. However, the asset must be completely worthless – under Reg. §1.165-5(f), no loss is recognizable due to a “mere market fluctuation” in the value of the asset.
We have long held the belief that worthless security treatment does not apply to most crypto assets for a couple of reasons: First, crypto assets do not meet the definition of securities under §165(g), which generally recognizes only stock in a corporation or a certificate of indebtedness issued by a corporation as a security. Second, it seems improper to take advantage of favorable wash loss rules based on the fact that cryptocurrencies are generally not considered securities, and then argue on the same tax return that the security classification should apply to cryptocurrencies so the taxpayer can take advantage of favorable worthless security treatment. And lastly, because most rugged coins may still be tradable on some exchanges, and being worth very little is not the same as being worthless.
In the case of the specific transaction to which CCM 202302011 applies, the IRS says, “Section 165 provides a deduction for losses that are evidenced by closed and completed transactions, fixed by identifiable events, and actually sustained during the taxable year. [The taxpayer] has not abandoned or otherwise disposed of the cryptocurrency, and the cryptocurrency is not worthless because it still has value.”
As has been mentioned before on this blog, realization events form the backbone of the Internal Revenue Code. In a situation where no realization event has occurred, there is no mechanism to recognize a tax loss from a rug pull or other substantial decline in value of a cryptocurrency held by an investor. The Chief Counsel Memorandum issued today agrees to this view.