Some investors who experienced rapid declines in the value of their cryptocurrencies during 2022 may be attempting to claim 2022 tax losses. According to the IRS’s Office of Chief 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 the substantial devaluation of cryptocurrency alone is not enough to claim a tax loss. In reaching this conclusion, the IRS addressed such threshold questions as (1) whether a cryptocurrency taxpayer can take a tax loss, (2) when a cryptocurrency taxpayer can take a tax loss, and (3) what the character of that tax loss is. While Chief Counsel Memoranda are not binding, not taxpayer specific, and subject to change without notice, they do at least provide insight on the IRS’s perspective on tax positions. 

In the Memo, a hypothetical taxpayer attempted to claim a Section 165 ordinary loss deduction, asserting that its cryptocurrency was either abandoned or worthless after the cryptocurrency declined in value from one U.S. dollar to less than one U.S. cent during the year of acquisition. In denying the deduction, the IRS focused on whether the losses satisfied the statutory requirement to be “sustained” in the tax year (i.e., they must be actually sustained, fixed by identifiable events, and evidenced by closed and completed transactions). In determining that the cryptocurrency was neither abandoned nor worthless, the IRS’s analysis focused on two facts: the taxpayer retained its cryptocurrency, and the cryptocurrency was still trading for some value in the market.  

As the taxpayer retained possession of its cryptocurrency, the IRS determined that the cryptocurrency was not abandoned since the taxpayer continued to have “dominion and control.” For an abandonment to occur, there must be both an intention to abandon the property and an affirmative act of abandonment. Therefore, the retention 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 within the statutory definition of worthless securities under Section 165(g), which generally treats securities such as stocks and bonds, which are capital assets in the hands of a taxpayer, as generating capital losses in the year they become worthless. The Memo provides, however, 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 “valueless.” As the cryptocurrency continued to trade at some amount greater than zero, the Memo determined it was not in fact “valueless.” Finally, even when an individual taxpayer could make a claim for an ordinary loss deduction, the Memo clarifies that Section 67(g) temporarily disallows miscellaneous itemized deductions by individual taxpayers, including losses other than casualty, theft, and wagering, until January 1, 2026. Although the Memo does not address this point, since corporate taxpayers are not subject to the disallowance for miscellaneous itemized deductions under Section 67(g), they presumably can still claim losses relying on either the abandonment or worthlessness approach, subject to satisfying the relevant legal standards.

Notably, the Memo and its lack of additional facts leave cryptocurrency taxpayers somewhat in the dark. For example, in the context of a claim for abandonment, no distinction is made between investors who acquire their cryptocurrency through a third-party exchange and others who do not hold their cryptocurrencies through intermediaries (i.e., whether an investor holding cryptocurrency through an exchange in an exchange hosted wallet has dominion versus the investor not holding through an intermediary). Furthermore, and as discussed here, it is not readily apparent how a taxpayer would affirmatively abandon their cryptocurrency absent selling it, although protocols do exist for taxpayers to transfer and therefore abandon their cryptocurrencies. In the context of worthlessness, the Memo does not address specifically what it means for cryptocurrency to become worthless. Presumably, the inability to find a buyer, even where the cryptocurrency is listed with a value above zero, would suggest that the cryptocurrency was in fact valueless. As a result, and absent additional information, a taxpayer could face the worst case scenario: holdings of cryptocurrencies with substantial losses that exist on an exchange, are listed for more than zero dollars, and for which no buyers are presently making a market. Not only is the taxpayer without guidance on how to abandon its cryptocurrency or claim its worthlessness, but the illiquid market for the cryptocurrency could mean that the taxpayer may also lack the ability to sell its cryptocurrency holdings and thereby recognize a capital loss, to the extent that its cryptocurrency is a capital asset.

All is not lost. Importantly, the Memo does not foreclose some investors from claiming loss deductions for their cryptocurrency holdings and may provide beneficial guidance for future tax years. Importantly, the Memo does not address the implications of so-called theft losses (discussed further here), beyond stating that theft losses would not be subject to the disallowance under Section 67(g), and therefore opening theft losses up as an avenue to claim a tax loss against ordinary income for the 2022 taxable year to the extent applicable. Likewise, for investors who otherwise disposed of their cryptocurrency in a sale or exchange during the 2022 taxable year and who would presumably be able to claim a capital loss, the Memo does not appear to limit their claim of a capital loss. Finally, for future tax years, the Memo may provide a roadmap for taxpayers attempting to utilize tax losses in their cryptocurrency portfolios. Accordingly, although the Memo forecloses some avenues for loss deductions, there may be additional avenues not addressed by the Memo that taxpayers may be able to utilize to claim a tax loss.