Crypto Losses Are Not All Alike

With the Crypto Winter as well as recent bankruptcies of various exchanges, taxpayers want to know how to best report their losses for tax purposes. There is no simple answer, and the proper tax reporting will depend on how the loss was incurred.

1. The value of my holdings went down substantially due to market conditions but they are still tradeable. Can I take a deduction for the diminution in value without selling the coins so as to avoid trading costs? A. No. While for GAAP accounting purposes declines in market value are expensed on the financial statements, for tax purposes there must be a sale. But the good news is that digital assets currently are not subject to the ”wash sale” rules that securities are subject to, so if you still want to keep the investment, you can buy it back immediately and “harvest” a tax loss.
2. Does the loss realized include the highest fair market value of the digital asset (“DA”) less the selling price or is it limited to the actual cost of the DA? A. The loss is limited to actual cost. So if your cost was $1,000, the DA became worth $10,000, and now its worth only $500, your true deductible loss on sale is $500, not $9,500.
3. The exchange I entrusted to hold my DA is frozen and is the process of being liquidated. Meanwhile, I don’t have access to my DA but they have declined substantially in value and are still traded on other exchanges. Can I take a loss for the decline in my cost basis? A. Likely not as they are still traded on other exchanges and the fact that they are locked into the frozen exchange does not allow you to create a completed transaction to take your loss. You may have to wait till the liquidation finalizes and the DA is tradeable again to calculate your loss.
4. I loaned my DA to a Defi exchange to stake or lend onwards and now the DA have become worthless and are no longer tradeable. Can I take a tax loss on the loan? A. You may be able to take a non-business bad debt deduction for the loan which is treated as a short-term capital loss. Such a loss is deductible against ordinary income to a limit of $3,000 per year but deductible against other capital gains to no limit. Any carryover of loss is carried over forever until used. These rules are complex and your specific facts would need to be addressed.
5. I placed my DA into an exchange, and they became worthless just based on market conditions. They are no longer trading. Can I take a “worthless” security deduction for the loss? A. DA are treated like property for tax purposes, not like securities. As such, they have to be “sold or exchanged” to trigger the loss, unlike securities where a “worthless” designation would allow the loss.
6. The exchange I used to hold my DA closed due to a “hack” of its assets. It is in liquidation, and I may have to wait several years to recoup a fraction of my investment. Can I deduct my loss as a theft/casualty loss? A. This is a controversial area. If it is a casualty or theft loss that triggered the closing of the exchange, the Internal Revenue Code does not allow such losses presently under a law that is effective through 2025. If the previous law, allowing theft losses, becomes law again as scheduled, and that is when the loss is crystallized, you should be able to take the loss then.
7. When the Madoff Ponzi scheme was discovered, the IRS issued several Revenue Procedures in 2009 allowing for ordinary losses to be taken at varying percentages depending on certain factors. Why wouldn’t the current bankruptcies or “hacks” qualify for similar treatment? A. The Madoff theft losses were direct losses by investors who had placed money with him, which he embezzled. Also, theft losses were allowed as ordinary deductions at the time. Present “hacks” of an exchange where individual DAs are stolen would seem to qualify for a direct theft but theft losses are not currently deductible at all until the present law sunsets in 2025. Also, if general embezzlement or theft of an exchange’s assets lead to its demise for lack of capital but there is not a direct link to the theft of assets of an individual, that is not considered a “theft” loss. These rules are complicated and each set of facts must be examined to determine what tax law might apply to allow some current tax loss.

There are still many facts that must be ascertained regarding the nature of the losses for FTX account holders and the causes that led to those losses. However, this article will now explore some additional potential remedies for taking deductible tax losses at some time in the future.

While “casualty and theft losses” of a personal nature are not currently deductible by individuals due to a moratorium on such losses that won’t end until after 2025, it may be possible to characterize such a loss as an “investment theft loss” under IRC Sec. 165(c)(2). This type of loss is not subject to the moratorium and results in an itemized deduction taken as an ordinary loss on Form 4684.

However, to qualify for this type of loss, the account had to have been established with an expectation of profit, there should be a “theft” under applicable state law, and there has to be a reasonable determination of the amount of the loss after considering the expectations of a recovery amount. It is unclear whether the facts at FTX have risen to this level of being able to ascertain with reasonable accuracy what a recovery might be, if any. In addition, it is unclear whether there was an actual theft or embezzlement of the account holder’s property or whether unsound business practices related to their business activities, with the related party, caused the bankruptcy. If the latter, the IRS does not view that as a theft loss. The Madoff case and Rev Procs 2009-09 and 2009-20 are useful in determining whether the FTX situation rises to the level of “investment theft loss.”

Finally, there is another avenue of approach to trigger loss recognition and that is the “abandonment” approach. The Code does not specifically mention abandonment losses but there are regs and numerous cases that have dealt with it and give us some guidance on how this works to create an ordinary loss (i.e., itemized deduction). The taxpayer would have to show an intent to abandon and some action that reflects that intent. In addition, there can be no consideration received by the taxpayer, not even the relief of liabilities, as that then creates a “sale or exchange” which while creating a loss, creates a “capital loss.”  Such losses are reported on Form 4797.

In the FTX context, it is uncertain how to communicate the intent to abandon and to whom. It may be that once a trustee in bankruptcy is established, the trustee becomes the proper recipient of proof of intent to abandon. If one is affected by the FTX debacle through a partnership that holds the account, it may be possible to inform the general partner of the partnership of one’s intent to abandon the partnership interest and trigger a loss. Naturally, the benefits of a loss in 2022 must be weighed against the prospects of some recovery. Also, if one holds tokens that have been impacted severely by the FTX bankruptcy, but no market exists on which to sell them, a transfer to a “null” account would serve to close the transaction so as to trigger the losses. Or some other method of “burning” the coin might trigger the loss but it is more likely a capital loss than an abandonment loss (to be determined based on facts and circumstances). Different wallets and different coins may have diverse ways of “burning” the coin and a careful review may lead one to either abandonment and ordinary loss treatment or capital loss treatment.

As tax returns are not due till the third quarter of 2023 with extensions, and as facts continue to come out daily, it may not be necessary to take action before year-end. Indeed, based on the accounts being frozen, it does not appear that any meaningful action can be taken other than the abandonment or burning route, if applicable. Please speak to your tax advisor before making any decisions.