IRS Sheds Light on Cryptocurrency Loss Harvesting | Cadwalader, Wickersham & Taft LLP
Some investors who experienced a rapid decline in the value of their cryptocurrencies during 2022 may be attempting to claim their 2022 tax losses. According to the IRS Office of Chief Counsel, some of these investors may be out of luck. On January 13, 2023, the IRS issued ILM 202302011 (the “Memo” reproduced here) stating that the substantial cryptocurrency devaluation alone is not enough to claim a tax loss. In reaching this conclusion, the IRS addressed threshold issues such as (1) whether a cryptocurrency taxpayer can suffer a tax loss, (2) when a cryptocurrency taxpayer can suffer a tax loss, and (3) what is the character of this tax loss. While the Chief Counsel’s Memos are non-binding, non-taxpayer-specific, and subject to change without notice, they at least provide insight into the IRS’s perspective on tax positions.
In the Memo, a hypothetical taxpayer attempted to claim an ordinary loss deduction under Section 165, claiming his cryptocurrency was abandoned or worthless after the cryptocurrency dropped in value from a US dollar to less than a cent. during the acquisition year. In denying the deduction, the IRS focused on whether the losses met the statutory requirement to be “incurred” in the tax year (that is, must be actually supported, fixed by identifiable events and evidenced by concluded and completed transactions). In determining that the cryptocurrency was neither abandoned nor worthless, the IRS’s analysis focused on two facts: the taxpayer kept his cryptocurrency, and the cryptocurrency was still trading for some value in the marketplace.
Because the taxpayer retained ownership of his cryptocurrency, the IRS ruled that cryptocurrency was not abandoned as the taxpayer continued to have “dominion and control.” For an abandonment to occur, there must be both an intention to abandon the property and an affirmative act of abandonment. Thus, the preservation of cryptocurrency nullified the abandonment argument. In clarifying whether cryptocurrency was worthless, the Memo provides that this type of cryptocurrency does not fall under the legal definition of worthless securities under Section 165(g), which generally treats securities such as stocks and bonds, which are capital assets. in the hands of a taxpayer, as they generate capital losses in the year they become worthless. The Memo provides, however, that an economic loss on the cryptocurrency could still give rise to a normal loss deduction under Section 165 generally if the cryptocurrency was indeed “worthless.” As the cryptocurrency continued to trade above zero, the Memo determined that it was not actually “worthless.” Finally, even when an individual taxpayer could apply for an ordinary loss deduction, the Memo clarifies that Section 67(g) temporarily prohibits various itemized deductions by individual taxpayers, including losses other than injury, theft and gambling, until as of January 1, 2026. While the Memorandum does not address this point, since corporate taxpayers are not subject to the prohibition of miscellaneous itemized deductions under Section 67(g), presumably they can still claim losses relying on the abandonment or of futility, provided you meet the relevant legal standards.
In particular, the Memo and its lack of additional facts leave cryptocurrency taxpayers somewhat in the dark. For example, in the context of an abandonment request, no distinction is made between investors who acquire their cryptocurrency through a third-party exchange and others who do not hold their cryptocurrencies through intermediaries (that is, if an investor who holds cryptocurrency through an exchange in an exchange hosted wallet has dominance over an investor who does not hold through an intermediary). Also, and as discussed here, it is not immediately apparent how a taxpayer would affirmatively abandon their cryptocurrency without selling it, although protocols exist that allow taxpayers to transfer and then abandon their cryptocurrencies. In the context of worthlessness, the Memo does not specifically address what it means for cryptocurrency to become worthless. Presumably, the failure to find a buyer, even if the cryptocurrency is listed with a value above zero, would suggest that the cryptocurrency was in fact worthless. As a result, and in the absence of further information, a taxpayer could be faced with the worst-case scenario: holdings of cryptocurrencies with substantial losses that exist on an exchange, are listed for more than zero dollars, and for which no buyer is currently making a market. . Not only does the taxpayer have no guidance on how to abandon their cryptocurrency or claim its worthlessness, but the illiquid cryptocurrency market could mean that the taxpayer may not even be able to sell their cryptocurrency holdings and therefore recognize a loss of capital. , to the extent that its cryptocurrency is a capital asset.
All is not lost. Importantly, the Memo does not preclude some investors from claiming loss allowances for their cryptocurrency holdings and may provide helpful guidance for future fiscal years. Importantly, the Memorandum fails to address the implications of so-called theft losses (discussed further here), other than stating that theft losses would not be subject to prohibition under Section 67(g), and thus opening the theft losses as an avenue to claim a tax loss on ordinary income for the 2022 tax year to the extent applicable. Similarly, for investors who otherwise gave up their cryptocurrency in a sale or exchange in fiscal year 2022 and who presumably would be able to claim a capital loss, the Memo does not appear to limit their request for a capital loss. Finally, for future fiscal years, the Memo could provide a roadmap for taxpayers attempting to use tax losses in their cryptocurrency portfolios. Accordingly, while the Memo precludes some avenues for deducting losses, there may be additional avenues not addressed by the Memo that taxpayers may be able to use to claim a tax loss.