Cryptocurrencies, a type of digital asset, can be a valuable source of tax losses.
In fact, harvesting tax losses at or near the end of the year is a well-recognized tax planning strategy. This entails selling crypto positions that have sustained losses and immediately buying them back. This is not available for other assets, such as stocks, given the wash sale rules. This only works for crypto as it is taxed as property rather than a security.
But what about cryptocurrency that has declined in value? What if the value is so low that the cryptocurrency is no longer traded? Can you take a loss based on the theory that the asset was worthless or abandoned?
The IRS recently addressed these questions in CCM 202302011.
Facts & Procedural History
In the given scenario, Taxpayer A purchased units of Cryptocurrency B in 2022 for personal investment purposes. After acquiring Cryptocurrency B, the value of the units declined significantly, with each unit being valued at less than one cent at the end of 2022. Despite this decline in value, Taxpayer A maintained control over the units and claimed a deduction on their 2022 tax return under Section 165, taking the position that the units were either worthless or abandoned.
Taxation of Cryptocurrency
Cryptocurrency is treated as property and that general tax principles applicable to property transactions apply.
The character of a gain or loss resulting from a disposition of cryptocurrency depends on whether the property is a capital asset in the hands of the taxpayer. If the taxpayer is not in the trade or business of dealing in cryptocurrency, they will generally realize a capital gain or loss on the sale or exchange of the cryptocurrency.
Section 165 provides for a deduction of losses sustained during the taxable year that have not been compensated for through insurance or other means. There are numerous court cases that address losses generally, such as losses on the abandonment of partnership interests. These cases generally say that there has to be some identifiable event to show the abandonment and be a closed and completed transaction.
IRS’s Position on Crypto Losses
That brings us back to the current IRS guidance. The IRS concluded that if a taxpayer owns cryptocurrency that has substantially declined in value and has not abandoned or otherwise disposed of the cryptocurrency, they have not sustained a loss under Section 165.
The IRS noted that a taxpayer can only deduct losses from cryptocurrency if the loss is incurred and reflected in closed transactions during the taxable year, and the loss is caused by a specific event that can be identified. It even referenced the partnership loss cases.
Thus, with crypto that just declined in value, the IRS reasoned that the cryptocurrency still has value, and therefore, the taxpayer has not sustained a loss under this section and the corresponding regulations.
The taxpayer may be able to take steps to sell the cryptocurrency to harvest the loss, however. This would no doubt constitute a closed and completed transaction, even if the crypto asset was subsequently repurchased in a later transaction, and it would be an identifiable event.
While cryptocurrencies can generate tax losses under Section 165, the losses must be evidenced by closed and completed transactions and fixed by identifiable events occurring in the taxable year. The decline in the value of cryptocurrency assets do not result in a loss under Section 165. This is especially true if the taxpayer does not abandon or otherwise dispose of the cryptocurrency and it still had value. The taxpayer may be able to take steps to sell the cryptocurrency to harvest the loss, however.