Claiming Cryptocurrency Losses as Tax Deductions
Introduction: Crypto Bankruptcies, Custodial Accounts, Misappropriation, Hacks, and Theft
Can digital asset or cryptocurrency investors that were customers or account holders in a failed cryptocurrency business claim a deduction for their digital asset or cryptocurrency loss? So far this year there have been four notable crypto bankruptcies: (i) Celsius Network, (ii) Three Arrows Capital, (iii) Voyager Digital, and (iv) FTX and FTX.US. These crypto bankruptcies left their investors and customers with large economic losses. The primary reasons for the cryptocurrency losses were because (i) the digital asset the customer held in the account abruptly and significantly dropped in value as a result of events that precipitated the bankruptcy, or (ii) the customer's custodially held assets disappeared through misappropriation, hacking of the platform, or were simply unaccounted for. Cryptocurrency investors and customers in this unfortunate position may be able to claim a deduction for their digital asset or cryptocurrency loss as a section 165(f) capital loss, a section 165(g)(1) worthless stock loss, or a section 165(e) theft loss.
Customer Assets Frozen in Crypto Bankruptcies
As we discussed in a prior post on the FTX collapse, customer assets were frozen prior to FTX's bankruptcy filing. After the bankruptcy filing the assets were inaccessible because of the automatic stay under the U.S. Bankruptcy Code. While it is not clear what the customers' economic recovery will be in the bankruptcy proceedings, their assets may be treated as property of the bankruptcy estate. Additionally, customers are likely to be treated as general unsecured creditors in the bankruptcy cases. As a result, their investment accounts and the assets they once held are likely to be satisfied for pennies on the dollar.
If a customer of a bankrupt crypto entity does not want to wait for the bankruptcy proceedings and the final distribution to creditors, the customer can sell its credit claims to distressed asset traders, usually at a steep discount. A customer that chooses to sell its credit claims to a distressed asset trader may recover less than if the customer waits for the bankruptcy proceedings to conclude; however, it has the advantage of quickly liquidating the claim, crystallizing (i.e., realizing) the customer's loss for tax deduction purposes, and avoids the uncertainty of a potential recovery in the bankruptcy proceedings. Regardless, whether a customer chooses to wait for the bankruptcy proceedings to conclude and the final distribution to creditors or if it decides to sell its credit claim to a distressed asset trader, a customer may be able to deduct its cryptocurrency loss as discussed in further detail below.
Claiming Digital Asset or Cryptocurrency Losses as a Section 165(f) Capital Loss
Requirements for a Section 165(f) Capital Loss
A customer of a bankrupt crypto entity may be able to claim a capital loss under section 165(f). This could apply to customers that sold digital assets or cryptocurrency at a loss prior to the bankruptcy filing, those that withdrew funds at a loss, or customers that wait for the bankruptcy proceedings to conclude with a final distribution to creditors. Section 165(f) provides that losses from sales or exchanges of capital assets shall be allowed to the extent allowed in sections 1211 and 1212. Section 1221 defines what constitutes a capital asset. It broadly defines what is a capital asset and a list of eight types of property that do not qualify as a capital asset. Most of the exclusions are not relevant; however, section 1221(6) provides that any commodities derivative financial instrument held by a commodities derivatives dealer is not a capital asset unless (i) it is established to the Secretary that the instrument has no connection to the activities of such dealer as a dealer, and (ii) the instrument is clearly identified in the dealer's records as being described in section 1221(6)(A) before the close of the day on which it was acquired, originated or entered into. We note that it remains unclear whether digital assets or cryptocurrencies should be treated as commodities for federal tax purposes. If they are and if the requirements of (i) and (ii) above are met such digital assets or cryptocurrencies should be treated as capital assets for purposes of section 1221.
Limitations on the Section 165(f) Capital Loss
Sections 1211 and 1212 limit the amount that individual taxpayers may deduct for losses from sales or exchanges of capital assets and provide rules for carrying forward to subsequent years the amount of any excess capital loss. In the case of non-corporate taxpayers, section 1211(b) allows losses from sales or exchanges of capital assets to the extent of gains from such sales or exchanges, plus, the lower of (i) $3,000 (or $1,500 if married filing individually) or (ii) the excess of such losses over gains.1 Thus, generally, non-corporate taxpayers can net capital losses against capital gains and if the excess of the losses over gains exceeds $3,000, non-corporate taxpayers can deduct $3,000 from ordinary income each year. The remainder of the excess capital loss will carry forward under the rules in section 1212. Generally, under section 1212 capital losses can be carried forward indefinitely until exhausted in the case of non-corporate taxpayers.2
It is important to remember that the amount of the capital loss is calculated as the taxpayer's adjusted basis in the capital asset minus the taxpayer's amount realized upon disposition of the capital asset (i.e., through a sale, withdraw, or claim liquidation in a bankruptcy proceeding). Note that claiming a capital loss under section 165(f) may not be desirable for a customer of a bankrupt crypto entity that has a large capital loss (i.e., high-basis in the digital asset or cryptocurrency) because of the limitations on deducting the loss in the year in which it occurs.
Claiming Digital Asset or Cryptocurrency Losses as a Section 165(g) Worthless Stock Deduction
If a customer's digital assets and/or cryptocurrency are hacked, lost, or never returned by a bankrupt crypto entity that custodially held such assets, the customer may consider claiming a worthless stock deduction under section 165(g)(1). As discussed above, it is unclear whether cryptocurrencies should be considered a stock or security for certain federal tax purposes. In Notice 2014-21, the IRS characterized virtual currencies as "property" for federal tax purposes. The IRS has broadened that characterization to all digital assets. Nonetheless, digital assets or cryptocurrency, as a subset of the broad category of "property" could also be treated as a stock or security for certain federal tax purposes. Note, that the IRS requires gains and losses from cryptocurrency to be reported on Form 8949, "Sales and Other Dispositions of Capital Assets" and that form is also used to report transactions regarding stocks or securities, among other items.
Customers holding digital assets or cryptocurrency in a bankrupt crypto exchange arguably held those assets for investment. Once the investment becomes worthless (i.e., it is clear that the assets will not be recovered), customers may be able to deduct the cost of the assets as a worthless stock deduction under section 165(g)(1). The transaction should be treated as a sale or exchange of the worthless stock or security for no consideration and the amount of the loss should be the customers' basis in the assets.
It is important to note that a deduction under section 165(g)(1) may not be available if the cryptocurrency exchange or bankrupt crypto entity makes a final distribution to creditors in satisfaction of their claims and the customer receives any amount in exchange for the customer's investments. If the customer receives some amount in exchange for its investment, the customer's stock or security is likely not worthless for purposes of section 165(g).3 As discussed, a worthless stock deduction may also be available in cases where a customer's digital assets and/or cryptocurrency are hacked or otherwise lost. Treas. Reg. § 1.165-1(c) provides guidance on the amount of the capital loss that is deductible and generally states that the limitations in sections 1211 and 1212 (described above) apply to worthless stock deductions.
Claiming a Crypto Theft Loss for Losses Resulting from Misappropriation, Hacks, or Theft
Requirements for a Section 165(e) Crypto Theft Loss
As we discussed in a prior post, theft losses are deductible provided that the requirements of section 165(e) and the regulations under section 165 are met. As a threshold matter, if the taxpayer receives compensation through insurance or a third-party for the loss, no portion of the loss for which reimbursement is received is allowed as a deduction.4 Thus, the taxpayer must show that he or she will not receive compensation through insurance or another third party for the loss. Additionally, the taxpayer must establish: (1) the occurrence of a crypto theft; (2) the amount of the crypto theft; and (3) the date the taxpayer discovered the crypto theft.
Treas. Reg. § 1.165-8(d) provides that a theft includes, but is not limited to, larceny, embezzlement, and robbery.5 In Rev. Rul. 72-112, the IRS stated "to qualify as a 'theft' loss within the meaning of Section 165[ ] of the Code, the taxpayer needs only to prove that his loss resulted from a taking of property that is illegal under the law of the state where it occurred, and that the taking was done with criminal intent." Taxpayers bear the burden of demonstrating that a theft occurred under applicable state or foreign law.
Moreover, a taxpayer must demonstrate the amount of the crypto theft. Generally, the amount of the crypto theft loss is the taxpayer's basis in the property. Treas. Reg. § 1.165-8(c) provides the rules for the amount of the crypto theft loss that is deductible. The regulation determines the amount of the loss by cross-reference to Treas. Reg. § 1.165-7(b)(1) and assumes a deemed sale under section 1011 and the fair market value of the property immediately after the theft is considered zero. Most importantly, taxpayers must have books and records reflecting their basis and the fair market value of the property at the time of the crypto theft.
The final requirement that taxpayers have to satisfy is they must show that the loss occurred in the tax year and that there is no reasonable prospect of recovery in the same year.6 Generally, the year of the discovery is the year in which a reasonable person in similar circumstances would have discovered the crypto theft loss.7 Treas. Reg. § 1.165-1(d)(3) provides that if there is a reasonable prospect of recovery in the year of the discovery, the timing of the deduction is delayed until the prospect of recovery no longer exists. Generally, this is a facts and circumstances determination.8
Timing and Limitations on a Section 165(e) Crypto Theft Loss
As discussed in detail in our prior post on theft losses, the taxpayer bears the burden of establishing that it is not receiving compensation from insurance or a third-party regarding the loss and that the requirements to claim a theft loss have been satisfied. The requirements for claiming a theft loss are based on all of the facts and circumstances and are highly fact specific. Taxpayers should conduct a thorough analysis of their facts against the relevant authorities to determine whether they may be able to claim a crypto theft loss deduction. If the requirements for theft losses are not satisfied, the taxpayer may be subject to disallowance of the deduction and significant penalties. Moreover, unlike section 165(f) capital losses or section 165(g) worthless stock deductions, theft losses are not subject to the loss limitation rules in section 1211. In other words, if the requirements are satisfied, the full amount of the loss may be deducted in the tax year when the loss is claimed. Finally, it is important to note that taxpayers are subject to a three-year statute of limitation in section 6511 on claiming the theft loss from the tax year in which there is no reasonable prospect of recovery.9 Taxpayers that unreasonably delay claiming a crypto theft loss may be denied the deduction once the period has lapsed.
Digital asset or cryptocurrency investors that were customers or account holders in a bankrupt crypto entity may be able to claim a deduction for their digital asset or cryptocurrency loss. Depending on the facts and circumstances of the cryptocurrency loss, a taxpayer may qualify for a capital loss under section 165(f), a worthless stock deduction under section 165(g), or a theft loss under section 165(e). As discussed, a critical difference between these three provisions is that cryptocurrency losses that are treated as capital losses and worthless stock losses are subject to the loss limitation rules in section 1211 while theft losses are not subject to section 1211. Investors that owned digital assets or cryptocurrency in custodial accounts in failed or bankrupt crypto entities should analyze the circumstances of their cryptocurrency loss against the relevant authorities to determine if any of the section 165 loss provisions described above may apply.
Tax Litigation and Controversy Attorneys
If you need assistance with claiming tax losses with respect to Cryptocurrency or Digital Assets that were held in custodial accounts or cryptocurrency, digital asset, or blockchain tax matters, Freeman Law can help you navigate these complex issues. We have experience analyzing and documenting tax losses arising from cryptocurrency or digital assets. We offer value-driven services and provide practical solutions to complex tax issues. Schedule a consultation or call (214) 936-3569 to discuss your tax concerns.
1 In the case of corporate taxpayers, losses from the sales or exchanges of capital assets are allowed only to the extent of gains from such sales or exchanges.
2 For corporate taxpayers, capital losses can be carried back three years, and forward for five years.
3 If an investor did not want to wait to take a deduction and was uncertain that a bankruptcy process would result in any recovery, the investor could choose to abandon its investment under Treas. Reg. § 1.165-5(i). Treas. Reg. § 1.165-5(i) provides "[t]o abandon a security, a taxpayer must permanently surrender and relinquish all rights in the security and receive no consideration in exchange for the security." The regulation also provides that all facts and circumstances determine whether a transaction is characterized as an abandonment. If a taxpayer successfully abandons its investment, the deduction under section 165(g) should be available for the tax year of the abandonment.
4 Treas. Reg. § 1.165-8(a)(2), Treas. Reg. § 1.165-1(d)(2).
5 See also Littlejohn v. Comm'r, T.C. Memo. 2020-42.
6 See I.R.C. § 165(e).
7 Cramer v. Comm'r, 55 T.C. 1125, 1133 (1971).
8 Treas. Reg. § 1.165-1(d)(2).
9 Taxpayers that realized digital asset or cryptocurrency losses as a result of a theft within the three-year statute of limitations and for which there was no reasonable prospect of recovery in one of those three years, may consider filing an amended return to claim the cryptocurrency losses as a section 165(e) theft loss on their return.
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