Cryptocurrency investors licking their wounds from the so-called crypto-crash shouldn’t get too creative when reporting their losses to the Internal Revenue Service, tax practitioners warn.
Most taxpayers will be subject to the traditional federal realized gain and loss rules, meaning investors in currencies such as Bitcoin, Ether and Dogecoin will see their losses after gains capped at $3,000, even if the net values of their digital wallets dropped hundreds of thousands—or millions—of dollars in the last month.
The same is likely true for investors in currencies that some view as “worthless,” like Luna, which lost as much as 99% of its value in recent weeks in a death spiral tied to its sister currency, the stablecoin Terra.
“As I see it, the capital loss limitation is set in stone, and I doubt digital currency would receive an exception carve-out going forward,” said Steve Howell, a tax practitioner with Heckard & Howell CPAs in Rock Hill, S.C.
The IRS has offered limited guidance on the tax treatment of cryptocurrency transactions, and declined to discuss its views on loss recognition in the context of the recent crypto crash. The agency referenced the capital-loss limit in an FAQ statement describing its primary guidance, Notice 2014-21, writing, “when you sell virtual currency, you must recognize any capital gain or loss on the sale, subject to any limitations on the deductibility of capital losses.”
A lively debate recently exploded on Twitter about whether crypto investors would be saddled with the federal capital loss rules, which limit taxpayer losses at $3,000 for a given tax year but permit leftover losses to be carried into future years.
In the context of the crypto selloff, it is possible for some tokens to drop to a value of zero, said Shehan Chandrasekera, chief of tax strategy for the income tax services company CoinTracker. In such a scenario, Chandrasekera argues, investors could use the federal abandonment loss provision to claim a full tax write-off for their worthless investments.
By way of example, he said, a $100,000 loss from an investment in Luna might cause an investor to wait 33.3 years to achieve the full tax benefit from the loss. Treating the $100,000 loss as an “abandonment loss” carries no $3,000 limit, allowing the taxpayer to “directly claim a 100K loss in your 2022 taxes,” Chandrasekera tweeted.
Chandrasekera didn’t respond to a request for comment, but in a blog published last year, he described an abandonment loss as a loss arising from the sudden termination of the continuance of a business or transaction that is permanently discarded. In these scenarios, the taxpayer is permitted a full deduction during the taxable year in which the loss is sustained, he wrote.
But that is a controversial position. Several practitioners advised against the use of the abandonment loss provision for most cryptocurrency investors.
Not true. Stop giving bad advice. You can take NO MORE THAN 3K IN LOSSES ABOVE YOUR CAPITAL GAINS for that year. 50k cap gains you can take 53k capital losses— Eric S. Jensen (@sonofyens) May 16, 2022
“It’s a position I would not advise anyone to take, nor would I sign a tax return with that position on it,” said Robert Tobey, chair of the American Institute of CPAs’ virtual currency task force and a partner at Grassi Advisors & Accountants in New York. “I think you’re looking for trouble.”
What Does ‘Worthless’ Mean?
The essential legal question is whether the property is truly “worthless,” said Matthew E. Foreman, a tax partner in the New York offices of Chiesa Shahinian & Giantomasi PC.
“The question of what is worthless is highly fact-specific,” he said. “So if you get audited, the IRS is likely to disagree and say ‘we don’t think you really abandoned it.’ There is a lot of case law on this, and I like to say ‘basically worthless’ is not the same as `worthless.’ If you think back to 2008 when the stock of Bear Stearns dropped to $1.30 and people were saying, ‘it’s worthless,’ I had to say ‘no, it’s worth $1.30.’ ”
Howell agreed, noting that markets continue to function even for cryptocurrencies where values have dropped below a penny. In that context, he said, the IRS likely wouldn’t view such assets as worthless.
“Even if something went from $100 per unit to .001, it sure as hell might look worthless,” Howell said. “But from a technical standpoint, if there is some liquidity, some market, and some counterparty, you can’t take that loss and claim it as worthless.”
Tobey, Foreman, and Howell agreed there might be scenarios where a cryptocurrency investment could be deemed worthless, but those will be rare and highly fact-specific. They advised taxpayers planning to apply the abandonment loss provision to closely document the steps they take to demonstrate the worthlessness of such assets and any strategies they employ to discard them.