By Jeffrey Maine
I’m a big loser . . . at least when it comes to investing. While “buy low, sell high” is a common investment strategy, I seem to do the opposite. My investments in cryptocurrencies are a recent example. In one instance, I invested $1,000 in a coin that was supposed to “go to the moon.” The last I checked, the account was worth 96 cents.
I’m not the only loser, however, when it comes to crypto losses. The crypto industry has been hit hard with various market forces and various pump-and-dump schemes and fraudulent transactions. Crypto exchanges have collapsed and bankruptcy filings are on the rise. Criminals have been employing hacking techniques to exploit computer and network vulnerabilities and seize tokens belonging to others. Many crypto owners have suffered losses simply because they forgot their passwords or mislaid their own private keys.
As my students know, I can turn any non-tax issue into a tax issue. So here we go: To what extent should the government permit an income tax deduction for losses sustained in crypto activity? It is an important policy question, which has yet to be critically addressed.
The IRS has long taken the position that convertible virtual currency is treated as property and that general tax principles applicable to property transactions apply to cryptocurrency. Deductibility of crypto losses under this “property” framework requires two things: (1) a realization event fixing the claimed property loss; and (2) specific statutory authorization for the claimed loss deduction.
“Realization” of Crypto Losses
Decreases in the value of crypto are not taken into account for tax purposes as they accrue over time, but only when they are realized—i.e., when there has been an identifiable event, such as a sale or other disposition of the crypto. A taxpayer would clearly experience a realization event if he or she (1) sold crypto for a price lower than paid, (2) engaged in a coin-to-coin trade, or (3) purchased property with crypto (viewed as a barter transaction in which crypto is exchanged for other property). But what about other crypto events in which the taxpayer doesn’t receive anything in return?
- Thefts of Crypto. A theft, like any casualty, can be considered an identifiable event for tax purposes. However, for a theft loss to be realized, the taxpayer must suffer a criminal taking of property under state law. State criminal statutes often require a degree of privity between the victim and the alleged perpetrator—a substantial roadblock to most crypto theft loss claims. Further, a theft loss is not deductible in the year of discovery to the extent the victim has a reasonable prospect of recovery. Many crypto owners involved in litigation (e.g., lawsuits alleging false advertising, misinformation, Ponzi schemes, or the like) have potential claims that could take years to resolve. And, even if recovery is possible, the dollar amounts are difficult or impossible to estimate, foreclosing any current loss deduction.
- Abandonments of Crypto. It is well established that abandonment of property is a realization/identifiable event for tax purposes. In general, there must be an intent to immediately and permanently cease using property, and the intention must be evidenced by the actions of the taxpayer/affirmative acts of abandonment. If a crypto owner misplaces a crypto key or password, he or she may be able to establish abandonment by making an effort to locate or retrieve the key or password and then determining that future efforts would be futile. Aside from lost possessions, the more difficult question is whether an abandonment loss could be sustained on the significant decline in value of crypto. In January 2023, the IRS issued guidance concluding that taxpayers do not sustain abandonment losses when crypto has substantially declined in value if the crypto continues to be traded on at least one crypto exchange and has a value greater than zero. The IRS raised the possibility of an abandonment loss deduction if necessary steps have been taken. But the IRS did not indicate what actions would qualify as abandonment.
- Worthlessness of Crypto. The concepts of “abandonment” and worthlessness are often conflated. In our tax system, worthlessness of an asset can support a loss deduction without the finding of abandonment. Applying general tax principles to cryptocurrency, a crypto owner must subjectively determine that the crypto is worthless and show objective indicia of worthlessness—that the crypto has no liquidation value or any potential future value. These are difficult hurdles in light of recent administrative guidance in which the IRS said crypto that continues to trade on an exchange—even if just for a fraction of a penny per unit—isn’t worthless for purposes of triggering a deductible loss. This position seems overly harsh.
For consistency and clarity of result, the government should issue additional guidance on these issues, as it did in the aftermath of the 2008 financial crisis when thousands of investors lost billions of dollars in fraudulent Ponzi schemes (such as those operated by Bernie Madoff). It could classify a certain category of crypto losses as “theft” losses and permit eligible victims to deduct a substantial portion of the loss in the discovery year rather than wait until the year potential claims are resolved. It could clarify steps that could be taken to “abandon” crypto, such as utilization of one of the protocols or websites held out as a place to abandon crypto. It could reconsider its position on crypto “worthlessness,” especially for crypto that might still be listed on an exchange but lacks a true market. It could adopt a safe harbor timing rule permitting crypto investors to claim worthless loss deductions upon identifiable events.
“Deductibility” of Crypto Losses
To claim a tax deduction for a realized/sustained loss, Congress must have specifically authorized the deduction. The Internal Revenue Code generally permits the deduction of investment losses. However, so-called capital losses (losses from sales or exchanges of capital assets) are allowed only if the taxpayer has capital gains for the year. Under this statutory framework, if a crypto investor sustains a loss on the sale or exchange of crypto, the otherwise deductible loss will be subject to the capital loss limitation rule. However, if the crypto purchased and held for investment is later stolen by hackers or abandoned by the taxpayer or becomes totally worthless, the loss will not be subject to the capital loss limitation rule.
Distinctions like these raise an interesting policy question: Is the capital loss limitation in the current tax framework sufficient, or should consideration be given to imposing additional loss restrictions for cryptocurrency? The government could consider a new tax framework for crypto loses—specifically, losses from cryptocurrency should only offset gains from cryptocurrency. Such a rule would not be based on moral disapproval of crypto trading as opposed to other investment activities. Instead, it would be supported by the unified justification underlying many loss limitation rules in our tax system—losses from one type of activity should not be used to offset or shelter income from another activity. Hobbies and gambling activities are good examples. Under our tax system, losses from your hobby activities can only offset income your hobby might generate. Likewise, losses from your gambling activities can only offset gambling winnings you might have.
These and other thoughts are reflected in a forthcoming article, entitled Crypto Losses, 2024 University of Illinois Law Review ___ (with Professor Xuan-Thao Nguyen).