IRS Releases Memorandum on Deducting Cryptocurrency Losses | JD Supra

In general, any loss suffered during a tax year in connection with a business or commercial activity or in a transaction conducted for profit is deductible under Section 165 of the Internal Revenue Code (Code), unless offset by insurance. or otherwise. A loss is considered incurred during the fiscal year in which it occurs if it is evidenced by closed and completed transactions, fixed by identifiable events, and, with certain limited exceptions, actually sustained during the fiscal year. A loss is not sustained to the extent that a claim for refund exists, if there is a reasonable prospect of recovery, until the fiscal year during which it can be determined with reasonable certainty that the claimed refund will not be received. The deduction is not allowed if the loss arises solely as a result of a decrease in the value of property owned by the taxpayer due to market fluctuations or other similar causes. However, a loss from theft is allowed and is treated as sustained during the tax year in which the taxpayer discovers the loss (as long as there is no claim for refund). Theft includes embezzlement, robbery and theft, among other concepts.

If any “security” that is a capital asset loses value during the tax year, the resulting loss is treated as a loss on the sale or exchange of a capital asset on the last day of the tax year. A security for this purpose means an interest in the stock of a corporation; a right to subscribe or receive a part of the shares of a corporation; or a bond, debenture, note, certificate, or other evidence of indebtedness issued with interest coupons in registered form by a corporation, government, or governmental political subdivision.

Abandonment losses incurred in a trade or business or in a transaction entered into for profit and arising from the sudden termination of profit in the trade or business or the transaction of any non-depreciable property may also give rise to a deduction if such business or the transaction is interrupted or when such property is permanently discarded from use therein. To prove final abandonment, the taxpayer must show an intent to abandon the property and an affirmative act of abandonment.

For individual investors who purchased cryptocurrency for personal investment purposes, worthlessness or abandonment losses are classified as miscellaneous itemized deductions. However, under current law, losses characterized as miscellaneous itemized deductions are not allowed for tax years beginning after December 31, 2017, and before January 1, 2026. Consequently, even if a taxpayer can establish losses for uselessness or abandonment before 2026, the deduction would be disregarded. Conversely, casualty, theft, and gambling losses are not classified as miscellaneous deductions and would not be disallowed.

IRS GUIDANCE ON CRYPTOCURRENCIES AND DEDUCTIONS FOR LOSSES

Facts

The memo considers a fact pattern in which a taxpayer purchased cryptocurrency in 2022 for personal investment purposes. After the taxpayer acquired the cryptocurrency, its value dropped significantly to the point where it was worth less than a penny by the end of 2022, although the cryptocurrency continued to be traded on at least one cryptocurrency exchange. The taxpayer maintained dominance and control over the cryptocurrency, even having the ability to sell, redeem, or transfer it. The taxpayer claimed a deduction on his 2022 tax return and took the position that the cryptocurrency was worthless or abandoned.

worthless cryptocurrency

The IRS stated that although the value of the cryptocurrency had decreased substantially, there was no deductible loss because its value was greater than zero, it continued to be traded on at least one cryptocurrency exchange, and the taxpayer did not sell, exchange, or dispose of it. . cryptocurrency The IRS relied on existing case law which states that “the mere decrease in property value does not create a deductible loss. An economic loss in property value must be determined by the permanent closing of a transaction with respect to the property. The decrease in value must be accompanied by some affirmative measure that fixes the amount of the loss, such as abandonment, sale or exchange.” Additional case law states that there must be an identifiable event that supports the fact that there is neither a current liquidation value nor a security to be acquired in the future. Because the cryptocurrency still had a liquidation value (even if it was valued at less than a penny) and because it was still possible for the value to rise in the future given that it was traded on at least one cryptocurrency exchange, the cryptocurrency in question it did not totally lose its value during 2022 as a result of its decrease in value and the taxpayer did not suffer a bona fide loss under Section 165(a) of the Code due to its lack of value.

abandoned cryptocurrency

To claim a loss under Section 165 of the Code for abandoned property, (1) the loss must be incurred in a trade or business or in a transaction entered into for profit, (2) the loss must arise from the sudden termination of the utility in trade, business, or transaction and (3) the property must be permanently disposed of from use or from a transaction that is discontinued. The IRS determined that the taxpayer did not abandon cryptocurrency in 2022 for purposes of Code Section 165(a) because the taxpayer failed to take any action to permanently abandon and discard cryptocurrency. The taxpayer also failed to demonstrate intent to abandon the property or demonstrate any affirmative act of abandonment.

Instead, the taxpayer maintained ownership of the cryptocurrency until the end of 2022 and retained the ability to sell, trade, or dispose of the cryptocurrency. Additionally, the taxpayer continued to exercise ownership and control over the cryptocurrency and, regardless of intent, did not take any affirmative action to relinquish ownership during 2022.

LIMITATIONS ON THE SCOPE OF IRS GUIDANCE

This guidance takes the form of a Senior Attorney Advisory Memorandum, which is typically issued to attorneys and revenue agents within the IRS. The memo has no precedent value and cannot be relied on (or cited as precedent) by taxpayers. However, many taxpayers take such guidance into account as it is helpful in understanding the current position of the IRS on a given issue, particularly when no other guidance is available. The IRS could take a different position on the same or a similar issue and such a position would not require withdrawal of the memo.

ROAD TO A DEDUCTION

Since miscellaneous itemized deductions may become available again in the future, taxpayers may still want to know how these deductions can be claimed. The memorandum provides that, in order for a taxpayer to make a deduction on a tax return for a loss under Section 165 of the Code, the taxpayer must show evidence of (1) an identifiable event that supports the fact that there is no value current settlement of the applicable cryptocurrency or any possibility of future appreciation or (2) intent to abandon the cryptocurrency, together with an affirmative act of abandonment.

In the past 12 months, many cryptocurrency protocols have been subject to exploits and hacks that have left taxpayers with theft losses in excess of $2 billion (e.g, the Ronin bridge hack and the Wormhole bridge exploit). During the same period, several cryptocurrency exchanges filed for Chapter 11 bankruptcy protection in the United States. With respect to theft losses, provided that such taxpayers can show evidence of the theft and the amount of the loss and are not entitled to receive any reimbursement through insurance or otherwise, such taxpayers may deduct such losses on their tax returns. taxes. However, with respect to cryptocurrency exchanges that are currently going through the Chapter 11 bankruptcy process, the answer is less clear given the uncertainty as to whether such taxpayers are entitled to a refund (e.gas creditor).

The most common way to abandon cryptocurrency is to send it to a null address (also known as a burn address), which takes the cryptocurrency out of circulation so that no one else can use it in the future. Such action must be treated as evidence supporting the loss of dominance and control over the cryptocurrency. Other methods of abandonment could involve transferring a taxpayer's right (or claim) to receive any currency to another party.

CONCLUSION

While the memo is useful in providing insight into how the IRS is considering cryptocurrency-related guidance, given the limited facts, questions remain as to whether a taxpayer can claim a deduction for cryptocurrency losses. For example, the memo does not provide any discussion of the tax consequences of a taxpayer not having the ability to abandon (or take other action with respect to) cryptocurrency since it is frozen on a cryptocurrency exchange (for example, in the case of a cryptocurrency exchange going through Chapter 11 bankruptcy proceedings that has suspended withdrawals and/or other actions).

While existing guidance states that Bitcoin and Ethereum are likely to be treated as commodities because futures for these cryptocurrencies are traded on a commodity exchange, as of March 28, 2022, the US Treasury Department ( Treasury) published the Fiscal Year 2023 Revenue Proposals and Green Book, which expanded the definition of security to include actively traded digital assets that are recorded in cryptographically protected distributed ledgers in other areas of the Code (for example, securities lending under the Section 1058 of the Code). Given recent events in the cryptocurrency industry in general, the Treasury may consider extending the definition of security to Section 165 of the Code, however no indication has been made.

The IRS has recently issued several memos on cryptocurrency-related issues, and IRS representatives have indicated that more guidance is coming soon.

Anthony Teng, a paralegal in the New York office, also contributed to this article.

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