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.
Conclusion
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.
Footnotes
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.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.