IRS Sheds Light On Harvesting Crypto Losses | Cadwalader, Wickersham & Taft LLP

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Some investors who experienced a rapid decline in the value of their cryptocurrencies in 2022 may attempt to claim tax losses in 2022. According to the IRS Office of Legal 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 substantial cryptocurrency devaluation alone is not sufficient to claim a tax loss. In reaching this conclusion, the IRS addressed issues such as (1) whether a cryptocurrency taxpayer may incur tax loss, (2) when a cryptocurrency taxpayer may incur tax loss, and (3) what is the nature of this tax loss. . Although the Chief Counsel’s memoranda are non-binding, not specific to taxpayers, and subject to change without notice, they do at least provide some insight into the IRS’ perspective on tax positions.

In the memo, a hypothetical taxpayer attempted to claim an ordinary loss deduction under Section 165, claiming that his cryptocurrency was either abandoned or worthless after the cryptocurrency decreased in value by one. US dollar to less than one US cent in the year of acquisition. In disallowing the deduction, the IRS focused on whether the losses met the legal requirement of being “sustained” in the tax year (i.e. they must be actually suffered, fixed by identifiable events and attested by closed and completed transactions). To determine that the cryptocurrency was neither abandoned nor worthless, the IRS analysis focused on two facts: the taxpayer kept their cryptocurrency, and the cryptocurrency was still trading for some market value.

As the taxpayer retained possession of their cryptocurrency, the IRS determined that the cryptocurrency was not abandoned since the taxpayer continued to have “dominion and control”. For surrender to occur, there must be both an intention to surrender the good and an affirmative act of surrender. Therefore, the custody of the cryptocurrency negated the abandonment argument. In clarifying whether the 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 deals with securities such as stocks and bonds, which are fixed assets in the hands. of a taxpayer, as generating capital losses in the year in which they become worthless. The memo, however, provides that an economic loss on cryptocurrency could still give rise to an ordinary loss deduction under Section 165 generally if the cryptocurrency was in fact “worthless.” As the cryptocurrency continued to trade above zero, the memo determined that it was in fact not “worthless.” Finally, even where an individual taxpayer could claim an ordinary loss deduction, the memo clarifies that Section 67(g) temporarily prohibits various itemized deductions by individual taxpayers, including losses other than accident, theft, and Paris, until January 1st. 2026. Although the memo does not address this point, since corporate taxpayers are not subject to the disallowance of miscellaneous itemized deductions under section 67(g), they can presumably still claim losses as a result. relying on the approach of abandonment or devaluation, subject to meeting the relevant legal standards.

Notably, the memo and its lack of additional facts leaves cryptocurrency taxpayers somewhat in the dark. For example, under a waiver 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 the intermediary bias (i.e., whether an investor holding cryptocurrency through an exchange in an exchange-hosted wallet has dominance over the investor not holding through the intermediary). Additionally, and as discussed here, it is not obvious how a taxpayer would affirmatively abandon their cryptocurrency without selling it, although there are protocols for taxpayers to transfer and therefore abandon their cryptocurrencies . In the context of worthlessness, the memo does not specifically address what it means for cryptocurrency to become worthless. Presumably, the inability to find a buyer, even when the cryptocurrency is listed with a value greater than zero, would suggest that the cryptocurrency was in fact worthless. As a result, and in the absence of additional information, a taxpayer could be faced with the worst case scenario: cryptocurrency holdings with substantial losses that exist on an exchange, are quoted for more than zero dollars and for which no buyer is not currently creating a market. Not only does the taxpayer have no guidance on how to abandon their cryptocurrency or claim its uselessness, but the illiquid cryptocurrency market could mean that the taxpayer may also not have the ability to sell. his crypto-currency assets and thus recognize a capital loss, insofar as his crypto-currency is capital.

All is not lost. Importantly, the memo does not prevent certain investors from claiming loss deductions for their cryptocurrency holdings and may provide helpful guidance for future tax years. It is important to note that the memo does not address the implications of so-called theft losses (discussed later here), beyond stating that theft losses would not be subject to denial under Article 67(g), and thus to open theft losses as a means of claiming an ordinary income tax loss for the 2022 tax year to the extent applicable. Similarly, for investors who otherwise disposed of their cryptocurrency in a sale or trade in the 2022 tax year and who would likely be able to claim a capital loss, the memo does not does not appear to limit their claim to a capital loss. Finally, for future tax years, the memo can provide a roadmap for taxpayers trying to use tax losses in their cryptocurrency portfolios. Therefore, although the memorandum excludes certain possibilities for deducting losses, there may be other avenues not addressed by the memorandum that taxpayers can use to claim a tax loss.

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