The crypto winter of 2022 has a number of those burned by the drop in price looking to see if there may be some sort of tax benefit they can claim based on their holdings dropping in some cases to virtually worthless.  But it turns out merely being virtually worthless virtual currency won’t deliver any sort of tax benefit, at least in the conclusions given in IRS Chief Counsel Advice 202302011.[1]

The memorandum is interesting for a number of reasons:

• The memorandum deals not with an actual taxpayer’s situation, but rather gives “non-taxpayer specific advice” to the requesting IRS employee

• The memorandum, dated January 10, 2023, was released in public form with no redactions on January 13, 2023

• The memorandum deals specifically with a 2022 crash in a stablecoin (one meant to hold a $1 per unit price) down to a price of below $0.01, something that happened in 2022 to stablecoins such as TerraUSD that failed to be as stable as they were hoped to be.

This appears to be an indirect way for the IRS to signal its position on various theories burned cryptocurrency investors might use to attempt to claim a loss on the 2022 income tax returns, warning them that the IRS plans to challenge such positions.

Issue Addressed in the Memorandum

The memorandum addresses the following question:

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?[2]

The question was based on the following hypothetical facts:

Taxpayer A is an individual who purchased units of Cryptocurrency B in 2022 at $1.00 per unit for personal investment purposes on a cryptocurrency exchange. After Taxpayer A acquired Cryptocurrency B, the per unit value of Cryptocurrency B decreased significantly, such that each unit of Cryptocurrency B was valued at less than one cent at the end of 2022. On December 31, 2022, Cryptocurrency B continued to be traded on at least one cryptocurrency exchange, and Taxpayer A maintained dominion and control over the units of Cryptocurrency B as evidenced by Taxpayer A's ability to sell, exchange, or transfer the units. Taxpayer A claimed a deduction on Taxpayer A's 2022 tax return under section 165 and took the position that the units of Cryptocurrency B were either worthless or abandoned.[3]

In a footnote, the memorandum points out that there are a number of such virtually worthless coins still being actively traded:

As of January 1, 2023, fifteen cryptocurrencies valued at less than one cent per unit were actively traded with market caps ranging from approximately $77 million to over $4.4 billion along with 24-hour trading volume ranging from $833,000 to $92 million. See www.coinmarketcap.com for cryptocurrency market values.[4]

Conclusion of the Memorandum

The memorandum comes to the following conclusion, which does not lead to a happy ending of the story for this hypothetical taxpayer:

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.[5]

Analysis of the Facts and the Law

The memorandum first discusses how the tax law views digital assets (the tax term that covers cryptocurrencies, NFTs and similar items):

Digital assets are defined under section 6045(g)(3)(D) as digital representations of value that are recorded on a cryptographically secured distributed ledger.1 Digital assets do not exist in physical form and include, but are not limited to, property the Service has previously referred to as convertible virtual currency and cryptocurrency. See Notice 2014-21, 2014-16 I.R.B. 938; Rev. Rul. 2019-24, 2019-44 I.R.B. 1004. Notice 2014-21 provides that convertible virtual currency is treated as property and that general tax principles applicable to property transactions apply to convertible virtual currency.

Cryptocurrency is a type of virtual currency that utilizes cryptography to secure transactions that are digitally recorded on a distributed ledger, such as a blockchain. Units of cryptocurrency are generally referred to as coins or tokens. Distributed ledger technology uses independent digital systems to record, share, and synchronize transactions, the details of which are recorded in multiple places at the same time with no central data store or administration functionality. See Rev. Rul. 2019-24.[6]

Such assets may be sold, exchanged or otherwise disposed of.  The general tax ramifications of such a disposal are briefly discussed:

Sales, exchanges, and other dispositions of digital assets may result in recognition of gain or loss. The character of a gain or loss resulting from a disposition of a cryptocurrency generally depends on whether the property is a capital asset in the hands of the taxpayer. A taxpayer not in the trade or business of dealing in cryptocurrency will generally realize capital gain or loss on the sale or exchange of a cryptocurrency. A taxpayer realizes ordinary gain or loss on the sale or exchange of property that is not held as a capital asset.[7]

Another way a loss might be recognized is under provisions found at IRC §165.  The memorandum first discusses losses under §165(a):

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).[8]

As well, the memorandum looks at another §165 provision governing recognition of a worthless security, but concludes it does not apply to the cryptocurrency in question:

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.[9]

Finally, the memorandum concludes its look at the law before looking at the specific tax results by looking at the interaction of losses under §165(a) with the disallowance of any deduction for miscellaneous itemized deductions under IRC §67(g) added by the Tax Cuts and Jobs Act:

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.[10]

Worthless Cryptocurrency

The memorandum first looks at whether a tax benefit is available based on the cryptocurrency in question being a virtually worthless coin.

But, as the analysis notes, virtually worthless is not the same as worthless.  And the coins in this case aren’t totally worthless:

Cryptocurrency B has substantially decreased in value; however, its value was greater than zero, it continued to be traded on at least one cryptocurrency exchange, and A did not sell, exchange, or otherwise dispose of the units of Cryptocurrency B. “The mere diminution in value of property does not create a deductible loss. An economic loss in value of property must be determined by the permanent closing of a transaction with respect to the property. A decrease in value must be accompanied by some affirmative step that fixes the amount of the loss, such as abandonment, sale, or exchange.” Lakewood Assocs. v. Commissioner, 109 T.C. 450, 459 (1997); Treas. Reg. section 1.165-1; see also Higgins v. Smith, 308 U.S. 473, 475 (1940) (“[D]eductions are permitted for losses 'sustained during the taxable year.' The loss is sustained when realized by a completed transaction determining its amount.”); United States v. White Dental Mfg. Co., 274 U.S. 398, 401 (1927) (“The statute obviously does not contemplate and the regulations forbid the deduction of losses resulting from the mere fluctuation in value of property owned by the taxpayer.”) (internal citation omitted).[11]

The memorandum notes that if there was actual worthlessness, a loss might be sustained under IRC §165(a):

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). 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).

In MCM Investment Management, LLC v. Commissioner, the Tax Court applied the tests articulated in Echols and Morton to determine whether a partnership interest was worthless and allowed a claimed loss deduction under section 165. T.C. Memo. 2019-158 at *26-31, *62 (citing Echols, 935 F.2d at 708; Morton, 38 B.T.A. at 1278). The Tax Court found that the petitioner subjectively determined that its partnership interest was worthless and, to determine whether there were also objective indicia of worthlessness, examined whether the partnership interest had liquidating value or any potential future value. Id. at *28-29, *31-32. Because the petitioner could recover nothing for its partnership interest upon liquidation of the partnership and because there was no potential future value due to the third-party subordinated debt agreements at issue, the Tax Court determined that the partnership interest was worthless. Id. at *58, *62.[12]

But the memorandum notes, this wasn’t the case in this hypothetical situation, thus no loss could yet be recognized:

In this case, each unit of Cryptocurrency B had liquidating value, though it was valued at less than one cent at the end of 2022. Cryptocurrency B continued to be traded on at least one cryptocurrency exchange, allowing for the possibility that it may increase in value in the future. Accordingly, Cryptocurrency B was not wholly worthless during 2022 as a result of its decline in value, and Taxpayer A did not sustain a bona fide loss under section 165(a) in 2022 due to worthlessness.[13]

Abandoned Cryptocurrency

The memorandum next looks at another option to trigger a loss under IRC §165(a), the abandonment of the assets:

Under Treas. Reg. section 1.165-2(a), a taxpayer sustains a loss under section 165(a) for the obsolescence or loss of usefulness of nondepreciable property if: “(1) the loss is incurred in a business or a transaction entered for profit; (2) the loss arises from the sudden termination of usefulness in the business or transaction; and (3) the property is permanently discarded from use, or the transaction is discontinued.” Franklin v. Commissioner, T.C. Memo. 2020-127 at *18 (citing Treas. Reg. section 1.165-2(a)).[14]

But, again in this hypothetical case, the taxpayer did not actually abandon the currency in question and thus did not sustain a §165(a) loss by the end of the year:

Taxpayer A did not take any action to abandon and permanently discard Taxpayer A's units of Cryptocurrency B during 2022. Abandonment is proven through an evaluation of the surrounding facts and circumstances, which must show: (1) an intention to abandon the property, coupled with (2) an affirmative act of abandonment. See Massey-Ferguson, Inc. v. Commissioner, 59 T.C. 220, 225 (1972) (citing Boston Elevated Railway Co. v. Commissioner, 16 T.C. 1084, 1108 (1951), aff'd, 196 F.2d 923 (1st Cir. 1952)). “The mere intention alone to abandon is not, nor is non-use alone, sufficient to accomplish abandonment.” Beus v. Commissioner, 261 F.2d 176, 180 (9th Cir. 1958), aff'g 28 T.C. 1133 (1957). Some express manifestation of abandonment is required when the asset is an intangible property interest. Citron v. Commissioner, 97 T.C. 200, 209-10, 213 (1991) (finding that taxpayer abandoned a partnership interest when the limited partners voted to dissolve the partnership, directed that a final partnership return be filed, and treated partnership property as no longer belonging to the limited partners).

In this case, Taxpayer A maintained ownership of Cryptocurrency B through the end of 2022, even though the value of each unit of the cryptocurrency as of the end of the year was less than one cent. Taxpayer A retained the ability to sell, exchange, or otherwise dispose of Cryptocurrency B during 2022. Furthermore, Taxpayer A continued to exert dominion and control over Cryptocurrency B and, regardless of intent, did not take any affirmative steps to abandon the property during 2022. Therefore, Taxpayer A did not sustain a loss pursuant to section 165(a) in 2022 due to abandonment.[15]

The memorandum notes that even if there had been actions to abandon and permanently discard the currency, there would still be two other hurdles to clear:

Because Taxpayer A did not take any action to abandon and permanently discard Cryptocurrency B, we need not discuss other requirements for a section 165 loss deduction, including the first two prongs set forth in Treas. Reg. section 1.165-2(a).[16]

The Reference to §67(g)

Note that even if the taxpayer had successfully shown that a loss under §165(a) had been incurred, the memorandum had noted in passing that such a loss would be a miscellaneous itemized deduction per IRC §67(b)(3), a type of deduction that was disallowed by the Tax Cuts and Jobs Act through 2025.

In that case, the last thing an investor would want is to actually trigger a §165(a) loss on the cryptocurrency by abandoning it. Nor would the investor want to be holding the coin when and if it became fully worthless, as that would also trigger the §165(a) loss.  Or, at least, not have either event occur before January 1, 2026 (assuming the TCJA provisions aren’t extended).

Rather the investor is left with selling or exchanging the virtually worthless coin in order to trigger a capital loss. But if the capital loss is more than $3,000 (and for many investors it will be orders of magnitude larger than $3,000) and the investor does not have a similar amount of capital gains in the year, the $3,000 limit on being able to deduct capital losses each year against ordinary income would severely limit the tax benefit recognized immediately, as the allowed losses dribble out onto the returns facing the $3,000 annual limit.

[1] CCA 202302011, January 13, 2023, https://www.irs.gov/pub/irs-wd/202302011.pdf (retrieved January 13, 2023)

[2] CCA 202302011, January 13, 2023

[3] CCA 202302011, January 13, 2023

[4] CCA 202302011, January 13, 2023

[5] CCA 202302011, January 13, 2023

[6] CCA 202302011, January 13, 2023

[7] CCA 202302011, January 13, 2023

[8] CCA 202302011, January 13, 2023

[9] CCA 202302011, January 13, 2023

[10] CCA 202302011, January 13, 2023

[11] CCA 202302011, January 13, 2023

[12] CCA 202302011, January 13, 2023

[13] CCA 202302011, January 13, 2023

[14] CCA 202302011, January 13, 2023

[15] CCA 202302011, January 13, 2023

[16] CCA 202302011, January 13, 2023