The January Effect: The US Internal Revenue Service Rules on Cryptocurrency Loss Harvesting
Janus, the two-headed Roman deity for whom the month January is named, could see the past and the future but not the present. The US Internal Revenue Service (“IRS”) must have been inspired by Janus when thinking about cryptocurrencies recently. On one hand, the IRS looked back to 2022 and issued puzzling but adverse guidance for individuals who were crushed in the cryptocurrency meltdown.1 Looking forward, the IRS postponed broker reporting for cryptocurrency transactions until after it issues final regulations on this topic.2 This Legal Update will explore both of these developments.
I. CCA 202302011
CCA 202302011 provides a relatively simple fact pattern. An individual investor purchases an on-exchange fungible digital token for $1.00 in 2022. After the cryptocurrency meltdown, the token is worth less than $.01 at year-end but is still traded on at least one cryptocurrency exchange. The taxpayer did not undertake any overt acts indicating that he abandoned the cryptocurrency. The taxpayer claims a tax loss for the diminution in value on his 2022 tax return on the theory that the token is either worthless or that he abandoned the token. There is no discussion as to whether the taxpayer was “gated,” that is, there is no discussion as to whether the exchange suspended redemptions so that the taxpayer was unable to sell the token.3 It’s worth noting that the “market price” is indicative of value only if the token can be sold. If the exchange is gated, the “market price” is pretty much illusory.
A. A Fool’s Errand
One has to wonder what prompted the IRS to issue the CCA in the first place. As we’ll explore below, the IRS considered two avenues that a taxpayer have could have considered in generating a 2022 tax loss from the extreme diminution in the value of the cryptocurrency—worthlessness and abandonment. But deductions for both of these events are suspended through the end of 2025.4 Accordingly, even if the taxpayer had been successful in establishing either worthlessness or abandonment, he would not have obtained any tax benefit. So why the IRS bothered considering these issues is a mystery. In each case, the taxpayer would be better off taxwise by sitting tight in 2022 and actually selling the depreciated cryptocurrency in 2023.
B. Worthlessness
Code § 165(a)5 provides a deduction for losses sustained during a year, provided that the loss is not compensated by insurance or otherwise. Treasury Regulation § 1.165-1(d)(1) states that the loss must be evidenced by closed and completed transactions evidenced by “identifiable events” occurring during the year. Courts have sustained the IRS’s position: “The mere diminution in value of property does not create a deductible loss.”6 The facts as posited by the IRS in the CCA clearly fell within this limitation. The IRS stated that the cryptocurrency was not worthless, although its value was nominal and that it could be sold. Accordingly, the IRS held that the taxpayer was not entitled to a loss deduction notwithstanding the fall in value of 99% to a nominal amount.
The loss from a worthless security is treated as a loss from a sale or exchange and, accordingly, would not be disallowed under the rules applicable to miscellaneous itemized deductions.7 The IRS has stated that cryptocurrencies are commodities8 and, accordingly, do not meet the definition of a security for this purpose.9 Thus, there did not appear to be a path for the taxpayer to avoid the disallowance of the non-deductible worthlessness deduction, even if one had been available.
C. Abandonment
After concluding that a worthlessness deduction was not available, the IRS considered whether a taxpayer could generate an abandonment loss with respect to the cryptocurrency. Abandonment requires three elements: (1) the loss was incurred in a transaction entered into for profit, (2) the loss arises from a sudden termination of usefulness and (3) the property is permanently discarded from use or the transaction is discontinued.10 Caselaw requires that the taxpayer show some overt express manifestation of abandonment.11 On the facts given in CCA 202302011, the taxpayer had no impediment to a sale of the devalued cryptocurrency and took no steps to evidence an abandonment. Accordingly, no non-deductible abandonment loss was available.
D. Theft Loss
In our experience, US cryptocurrency traders and investors were generally cognizant of the need for a closed and completed transaction in order to claim a loss. There was a flurry of selling of cryptocurrencies at the end of 2022 as taxpayers crystallized their cryptocurrency losses. Those taxpayers who did not sell most likely were prevented from doing so by the collapse of the various exchanges. This fact, not even considered by the IRS, leads to the question as to whether a gated investor could claim a 2022 theft loss.
Deductible casualty losses include theft losses.12 A theft loss from a transaction entered into for profit is not subject to the limitations on casualty losses.13 Theft losses generally are ordinary in character unless they relate to a sale or exchange transaction.14 Furthermore, these losses are not treated as miscellaneous itemized deductions, so any deduction arising from such a series of events would not be suspended.15 A theft loss is not available if there is a reasonable possibility of recovery.16 A theft loss arises from any criminal appropriation of another’s property.17 A criminal conviction, however, is not required to sustain a theft loss.18
Revenue Ruling 2009-9,19 an investor in a managed account discovered that the account manager was conducting a Ponzi scheme. Under the Ponzi scheme, the account manager issued fraudulent statements and used money from new investors to make distributions to investors who had established managed accounts in earlier periods. The fraud scheme constituted embezzlement, a criminal activity. The fraud scheme was discovered in “year 8.” The investor did not receive any reimbursement or recovery in year 8. Revenue Ruling 2009-9 concludes that the embezzlement loss is an ordinary loss under Code § 165. The IRS issued a Revenue Procedure to assist taxpayers in taking advantage of the holding of Revenue Ruling 2009-9.20
To the extent that there is no claim for reimbursement of the loss, theft losses are deductible in the year in which the taxpayer discovers the loss.21 Revenue Ruling 2009-9 does not address whether the holder of the managed account had a reasonable claim for recovery of the loss. The Ruling sates that such issue is a question of fact to be determined by examining all of the surrounding facts and circumstances. In Vennes, Jr. v. Comm’r,22 a taxpayer caught up in the Petters scam (a national scale fraud involving the issuance of billions of dollars of bogus receivables) sought to take advantage of Revenue Ruling 2009-9 in 2008 to claim a theft loss for his purchase of bogus receivables. At that time, a bankruptcy of the Petters firm had just commenced and there were substantial assets in the bankruptcy estate. These assets ultimately resulted in a recovery of a portion of the amount that the taxpayer lost. The court determined that, as of the end of 2008, there was a reasonable prospect of some recovery due to the existence of assets in the bankruptcy, the place the taxpayer held in a distribution of assets, the prospect of recovery against perpetrators of the fraud and the taxpayer’s involvement in the fraud.
At least one commentator looking at individuals caught up in the FTX meltdown has concluded that the answer to whether cryptocurrency investors can claim a 2022 theft deduction is an unqualified “Nope.”23 Many of the exchanges that suspended redemptions possessed some amount of assets making at least a partial recovery likely. In addition, at least a portion of the losses sustained by investors is attributable to market revaluations of cryptocurrency and such losses would not qualify as theft losses.24
II. IRS Announcement 2023-2
The Infrastructure Investment and Jobs Act (“Jobs Act”) amended Code §§ 6045 and 6045A to require brokers (broadly defined) to provide tax reporting with respect to digital assets, including cryptocurrencies. The reporting would include basis reporting and reporting of transfers between brokers. The Jobs Act provides that these new reporting requirements apply to transactions occurring in 2023.25 The complexity of the implementation of these rules effectively prevents market participants from complying with the new reporting rules without detailed guidance. In Announcement 2023-2, the IRS stated that the new reporting rules would not apply until new final IRS regulations implementing the digital asset reporting rules.
Thus, for everything that went wrong in the cryptocurrency markets in 2022, the IRS shone a light of hope on the new reporting rules for the future.
***
Mark Leeds (mleeds@mayerbrown.com; (212) 506-2499) is a tax partner with the New York office of Mayer Brown. Mark’s professional practice focuses on the taxation of financial products and financial institutions. Mark recently chaired a panel of international tax professionals addressing cryptocurrency tax issues at the International Bar Association annual meeting: https://www.mayerbrown.com/en/perspectives-events/events/2022/11/crypto-blockchain-and-fintech-can-tax-keep-pace-with-technology. Mark thanks Lee Sheppard (lee.sheppard@taxanalysts.org) for providing a reality check on an earlier version of this Legal Update. Mistakes and omissions, however, remain the sole responsibility of the author.
1 Chief Counsel Advice Memorandum 20230211 (Jan. 13, 2023).
2 IRS Announcement 2023-2 (December 2022).
3 FTX was the largest cryptocurrency exchange to suspend redemptions and declare bankruptcy in 2022. It is also worth noting that Genesis Global Capital, Babel Finance, Binance, and Celsius suspended redemptions in November 2022. Genesis declared bankruptcy in January 2023.
5 All “Code §” references are to the Internal Revenue Code of 1986, as amended.
6 Lakewood Assocs. V. Comm’r, 104 TC 450 459 (1997), cited with approval in CCA 202302022.
8 IRS Notice 2014-21, 2014-16 IRB 938.
11 See Citron v. Comm’r, 97 TC 200, 213 (1991).
14 Rev. Rul. 2009-9, 2009-14 IRB 14.
16 Treas. Reg. § 1.165-1(d)(3).
18 Vietzke v. Comm’r, 37 TC 504 (1961), acq. 1962-2 CB 6.
19 2009-14 IRB 735 (This Ruling is generally known as the “Madoff Ruling” as it was issued to provide guidance to individuals who suffered losses by investing with Bernard Madoff.)
20 Rev. Proc. 2009-20, 2009-14 IRB 749.
23 Sheppard, When Can Holders Recognize FTX Losses?, Tax Notes Magazine (Dec. 5, 2022).
25 Oddly, Section 80603(c) of the Jobs Act provides that the new reporting applies to statements that must be filed after December 31, 2023. Such statements would include transactions occurring in 2023.
