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The L Word: A Practical Guide to Deducting Cryptocurrency Losses

June 30, 2022, 8:45 AM

The digital asset or crypto ecosystem has experienced a series of ups and downs. Some crypto investors have been unsuccessful following the internet financial advice of professional boxers who had chosen a career of getting punched in the face. US taxpayers who have lost money on their digital asset investments, or had them stolen, may be able to hard fork lemonade classic tokens out of lemons by deducting tax losses.

Capital Losses From Sales or Exchanges

A taxpayer’s most typical losses are capital losses from the sale or taxable exchange of a crypto asset. Capital losses can offset capital gains, both long-term and short-term, and up to $3,000 per year of ordinary income.

Example: Bette purchased some titan for $200,000. She converts the titan into iron later in the year, at a time when her titan was worth $900,000, and recognizes $700,000 of taxable short-term capital gain. In year two, she sells the iron for $100,000 and recognizes $600,000 of capital loss in year two.

The year-two capital loss can only be carried forward, indefinitely. They cannot be carried back to year one to offset the capital gains and any ordinary income in year one—such as the liquidity pool yield rewards with annual percentage yields of somewhere between 20% and 4,000,000,000%.

The technique of paying a large tax at ordinary income rates, and then generating significantly less useful capital losses after selling in a falling market, is sometimes considered a huge tax break that “may sound like cheating, but it’s legal.”

Abandonment or Worthlessness Loss

In contrast with capital losses from sales or exchanges, abandoned or worthless crypto results in ordinary losses. But the catch is that the ordinary losses are miscellaneous itemized deductions that are not deductible until 2025. Accordingly, it is better to get out early by selling the assets (see above) or to have them stolen (see below).

The Tax Cuts and Jobs Act of 2017 provides that an individual’s miscellaneous itemized deductions are not deductible in 2018 through 2025. The tax code defines “miscellaneous itemized deductions” as generally all deductions other than: deductions that reduce adjusted gross income, such as trade or business deductions or losses from the sale or exchange of property; deductions for interest and taxes; casualty or theft losses incurred in any transaction entered into for profit; charitable contributions; and various other minor categories.

Abandonment or worthlessness losses from an investment asset are not any of the above categories and are therefore nondeductible miscellaneous itemized deductions.

Example: Helena purchased $5,000 of luna, a few days before it plunged to $0.001 in value. She experiences difficulties selling the luna because it is hard to be paid a fraction of a cent. She ends up too late with a $5,000 abandonment or worthlessness loss that is not deductible.

Abandonment or worthlessness losses are more useful as above-the-line deductions that reduce adjusted gross income if they arise from a trade or business, such as an initial coin offering trading business or a retailer that accepts shiba inu in payment.

Theft Losses

In 2008, many individuals lost their invested funds to Bernie Madoff, who generated a 10.5% annual return that turned out to be an unsustainable Ponzi scheme. The Madoff losses were itemized deductions that can offset an unlimited amount of ordinary income. The Madoff losses were not “miscellaneous itemized deductions” because they fit within the exception in the third category above, as theft losses incurred in any transaction entered into for profit.

Example: Carmen has a tax basis of $20,000 in her dogecoin investment, all of which she uses to buy a non-fungible token (NFT) of a cantankerous capybara limited-edition series. If the purchase is successful, Carmen recognizes taxable gain equal to the appreciation in the dogecoins that are exchanged for the NFT. But she becomes the victim of a domain name system poisoning attack and mistakenly sends the dogecoins to a hacker. Carmen can deduct the $20,000 theft loss as an itemized deduction. The loss event should meet the definition of theft in her local jurisdiction.

Example: Leisha finds that her bitcoin cold storage wallet was emptied because someone was able to decrypt her private key using a quantum computer. Under her local criminal law, the event may not count as a theft because no false pretenses or other misrepresentations were involved.

Conclusion

For tax loss purposes, it is generally best to be scammed. Stolen investment assets result in ordinary itemized deductions that can offset an unlimited amount of ordinary income in the same year. An investor who owns cryptokitties with significant unrealized losses can be better off if the cat pictures were stolen rather than sold.

Unused itemized deductions cannot be carried forward. In contrast, capital losses from sold assets can be carried forward to use against subsequent years’ capital gains and $3,000 of ordinary income each year. Least useful are abandonment or worthlessness losses from investment assets, which are disallowed through 2025.

A taxpayer’s tax losses are reduced to the extent that the taxpayer is later compensated for the loss, such as if the taxpayer wins a lawsuit against token sponsors, venture capital firms, Instagram influencers, Twitter promoters, and other parties for facilitating an unregistered securities offering.

All of the above deductions require that the taxpayer have a for-profit motive in owning the digital asset. Lack of a profit motive may result in deductions being disallowed by the Section 183 hobby loss rules. Fortunately, the for-profit motive need only be subjective, even if such motivation may be objectively lacking for algorithmic stablecoins in light of the experiences of basis cash, empty set dollar, bitUSD, digitaldollar, nubits, CK USD, iron finance, Terra USD, and DEI.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Libin Zhang is a tax partner at Fried, Frank, Harris, Shriver & Jacobson LLP in the New York office. In addition to crypto, decentralized finance (DeFi), and centralized finance (CeFi) matters, he also sometimes works with traditional finance (TradFi), real estate (ReEs), and tangible collectibles (TaCo).

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