The IRS has stated that a decline in the value of a cryptocurrency or NFT does not qualify as a loss under IRC section 165. Actually disposing of the asset will be required in order to take the deduction in the majority of cases, although there are some exceptions.
It’s popular in certain crypto circles to claim that actually selling your essentially worthless crypto or NFTs (or sending them to a null address) is not required in order to take a deduction. Multiple times I’ve seen “advice” being given along the lines of “don’t sell your worthless tokens or NFTs to tax-loss harvest. Write it off like worthless inventory. But then if it does recover you can sell it still!”
There are some pretty clear holes in that reasoning, some of which we covered in our article on how to write off worthless crypto assets. But the IRS recently issued additional guidance reinforcing our position.
IRS: Decline in Value Not a Deduction
On January 10, 2023 the Office of Chief Counsel Internal Revenue Service released Memorandum 202302011 (CCA 202302011), responding to whether or not section 165 was applicable for cryptocurrency that has declined in value:
“Issue
Section 165 of the Code provides for the deduction of losses sustained during the taxable year. If Taxpayer A owns cryptocurrency that has substantially declined in value, has Taxpayer A sustained a loss under section 165 of the Code due to worthlessness or abandonment of the cryptocurrency?”
Unsurprisingly, the IRS answered that it does not apply:
“Conclusion
No. Section 165 provides a deduction for losses that are evidenced by closed and completed transactions, fixed by identifiable events, and actually sustained during the taxable year. Taxpayer A has not abandoned or otherwise disposed of the cryptocurrency, and the cryptocurrency is not worthless because it still has value. Therefore, Taxpayer A has not sustained a loss under section 165 and the corresponding regulations. Further, even if Taxpayer A sustained a loss under section 165, the loss would be disallowed because section 67(g) suspends miscellaneous itemized deductions for taxable years 2018 through 2025.”
So what was the IRS’s reasoning as to why cryptocurrencies do not qualify for this deduction?
Casualty Loss Limitations Strike Again
The IRS memo highlights two areas of section 165 that taxpayers may attempt to use trying to deduct their cryptocurrency losses: section 165(a) and section 165(g). And they note in their analysis why neither section would apply, at least through 2025 (emphasis ours):
“Section 165(a) of the Code provides a deduction for losses sustained during the taxable year and not compensated for by insurance or otherwise. A loss is allowed as a deduction under section 165(a) only for the taxable year in which the loss is sustained. For this purpose, a loss is treated as sustained during the taxable year in which the loss occurs as evidenced by closed and completed transactions and as fixed by identifiable events occurring in such taxable year. Treas. Reg. section 1.165-1(d)(1).
For individual taxpayers, section 67(b)(3) characterizes section 165(a) losses, other than those from casualty, theft, and wagering, as miscellaneous itemized deductions. Under current law, section 67(g) disallows all miscellaneous itemized deductions for tax years beginning after December 31, 2017, and before January 1, 2026.”
“Section 165(g) provides that if any security which is a capital asset becomes worthless during the taxable year, the loss shall be treated as a loss from the sale or exchange of a capital asset. Section 165(g)(2) defines a security as a share of stock in a corporation; a right to subscribe for, or to receive, a share of stock in a corporation; or a bond, debenture, note, or certificate, or other evidence of indebtedness, issued by a corporation or a government or political subdivision thereof, with interest coupons or in registered form. Cryptocurrency B is none of the items listed in section 165(g)(2), and therefore section 165(g) does not apply.”
Essentially:
- The cryptocurrency losses would not qualify under section 165(a) because of the limitations to casualty and theft losses from the Tax Cuts and Jobs Act (TJCA)
- Since crypto is not classified as a security, it does not qualify for the special rules for stocks and bonds as defined in section 165(g)
(The IRS’s reasoning on section 165(g) is consistent with their application of section 170(f) as outlined in Memorandum 202302012 (CCA 202302012). That memorandum was issued on the same day as CCA 202302011 and discussed whether or not crypto donations were exempt from the qualified appraisal requirement for donations over $5,000. The IRS concluded that because cryptocurrency is not classified as a security, the exception does not apply. You can read more about this in our article discussing that memorandum.)
Alternatives Ways to Write Off Losses Without Disposition
But that does not mean that there are no alternatives available, although it should be noted that they are not without their own risks. The question the IRS was asked – and their answers above – are specifically regarding cryptocurrency that has declined in value, not that has no value at all. The IRS even discusses this later in the memorandum:
“A loss may be sustained, however, if a cryptocurrency becomes worthless, resulting in an identifiable event that occurs during the tax year for purposes of section 165(a). Whether an asset has become worthless is a question of fact. Boehm v. Commissioner, 326 U.S. 287, 293 (1945). In the case of a worthless asset, it is not necessary to relinquish title where there is a “subjective determination of worthlessness in a given year, coupled with a showing that in such year the asset in question is in fact essentially valueless.” Echols v. Commissioner, 935 F.2d 703, 708 (5th Cir. 1991).”
That’s great – especially for NFT investors and investors in low-liquidity projects where actual disposition of the asset may be more difficult. But as noted previously, taking this stance on an asset’s worthlessness without actually disposing of it comes with some risks. The IRS itself states that “whether an asset has become worthless is a question of fact” and that it is a “subjective determination of worthlessness”.
They further clarify that:
“In Morton v. Commissioner, the Board of Tax Appeals explained that “[t]he ultimate value of stock, and conversely its worthlessness, will depend not only on its current liquidating value, but also on what value it may acquire in the future through the foreseeable operations of the corporation. Both factors of value must be wiped out before we can definitively fix the loss.” 38 B.T.A. 1270, 1278 (1945)”
Subjectivity of “Worthlessness” Is Problematic
And that subjectivity – and perhaps even the mindset of the crypto investor themselves – is going to be problematic. The reason many investors are not disposing of their nearly worthless tokens/NFTs is not because of the gas fees to send them to a null address, it is because they are hoping that the value will later recover. And despite what they may be trying to tell the IRS, the assets do still retain some value – albeit greatly diminished.
And very importantly, it is not just current value that determines worthlessness. The potential value in may gave “in the future through the foreseeable operations” is also a consideration. And both factors – present and potential future value – must be completely wiped out in order to deduct the loss.
If you are holding onto the asset for anticipated future value, you need to consider whether or not the asset is truly worthless based on those criteria.
Even if you do firmly and honestly believe the asset to be worthless, that is still subjective and a matter of opinion. Even if you personally consider it worthless, there is no guarantee that the IRS will agree with you in the event of an audit.
True Abandonment Preferable in Certain Ways
Given all of these factors, taking the steps to actually abandon the assets is a cleaner and safer approach – at least from a tax planning standpoint. From an investing standpoint, you obviously do lose any upside if the NFT or token did miraculously recover down the road. But again, if that exists, you do not have a worthless asset to begin with.
Abandoning the property makes it much clearer that the asset is worthless, completely disposed of, and in no way still in your possession. This leaves much less for the IRS to argue about and makes an attempt to disallow the deduction much less likely.
With that said, if a taxpayer fails to take the steps to formally abandon the property before the tax year closes but still wants to take the write-off, it is still possible to take the deduction – albeit with some additional risk.
Any accounting, business, or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.
