When a cryptocurrency becomes worthless it isn’t treated the same as a worthless security on a tax return. As an asset, it needs to be sold before a loss is allowed. There are two ways you can get a tax deduction for worthless and nearly worthless crypto. We will discuss both methods (sale of asset and abandonment) below and the associated risks.
It is important to note that this is a complex area of tax law with several pitfalls. Sale of crypto assets may not be possible through normal channels (i.e., crypto exchange suspending transfers) and abandonment can be difficult to prove when all required steps for a tax deduction are unavailable.
In this article I will cover as many options as possible so the most amount of readers can benefit. It is important to read the entire text as there are many ways to run afoul of the tax laws in this area, ways that may seem reasonable at first, yet run afoul of one or more doctrines.
Sale of Worthless Crypto
The easiest way to deduct a loss on crypto is simply to sell the asset. When the exchange where the asset is held is functioning there is no issue. However, bankruptcy and fraud have rocked several crypto exchanges with systemic risk adding to the difficulty in selling crypto assets.
Even if you can’t sell an asset via traditional methods, you can still sell the asset in a legal exchange. In a legal exchange an attorney would draft a document transferring the asset. A 1099-B is unlikely to be issued in such circumstances so you will need accurate records to file your tax return.
In the crypto world the legal transfer is beneficial for owners of a personal crypto wallet where the password is nonrecoverable, as well. And, of course, to the large number of crypto investors with coins on exchanges that no longer allow asset transfers. Also, a crypto that no longer trades or has dropped to zero can benefit from a legal exchange.
Here is where the investor needs to be careful. There are investors that actively buy severely distressed assets. Who you sell to and the reason for selling come into play.
First, we need to address the “who” you sell to.
There is no prohibition against selling an asset to a related party. However, the loss realized upon the sale is not deducible (IRC §267). A related party is a brother or sister (whole or half blood), spouse, ancestor (parent, grandparent…) or lineal descendant (child, grandchild…).
When/if the related party sells the asset there can be tax consequences to both parties of the original transaction.
Sale of an asset to a non-related party bypasses related-party restrictions and is reported currently. Losses can offset other capital gains and up to $3,000 against other income.
Arm’s Length Transactions
With related-party sales not helping reduce your tax liability, you might be tempted to take another route you control completely.
The temptation is to organize an entity that will purchase your depressed crypto assets. Maybe you already own a business organized as an LLC or a corporation. However, if you control the entity (controlled parties) you do not have an arm’s length transaction and the loss is not allowed (IRC §482).
While you can sell to a related party or have a non-arm’s length transaction, it does not help you reduce your current tax liability. Selling to a non-related party or an entity not controlled by the seller opens the door to a potential tax deduction.
Before we jump into to selling our crypto assets under a legal exchange, we need to review a few doctrine that govern under tax law.
Business Purpose Doctrine
A transaction with the sole purpose of avoiding taxes faces significant challenges. Reducing taxes can play a role in the transaction, but it can’t be the sole purpose of the transaction [Mel Dar Corp. v. Commissioner, 309 F.2d 525 (9th Cir. 1962)].
The question with crypto when it comes to the business purpose doctrine involves transactions between individual investors. A business needs to have a bona fide business purpose for the transaction. Is crypto sold to an investor a business transaction subject to the business purpose doctrine? Or is it just two investors, a buyer and a speculator?
Since crypto is so new there is a real possibility some of these issues will be determined in Tax Court. The final outcome will depend on facts and circumstances. Is the buyer treating the purchase of distressed crypto as a business or as an investor? Since an investor does not take a current deduction on an asset purchase (crypto is a non-depreciable indefinite-lived intangible asset) there should be no business purpose issues. However, if purchases are conducted as a business there needs to be a business purpose. Long-term gain, even when highly speculative is still a business purpose.
Sham Transaction Doctrine
Once again we have a doctrine focused on a business motive, only with the sham transaction doctrine an investment motive also is considered.
A lot of issues can turn a transaction sham. Who retains control of the asset? What is the transaction price? And more questions have to be answered.
Price is the topic avoided thus far. The price that an asset transfers at is a wide road. Crypto in a locked exchange (bankrupt, insolvent, under government restrictions or any other situation where sale of crypto assets is unallowed currently) or frozen wallet (lost key to a personal wallet) might be worth a lot in the future or worth zero until the end of time. These transactions will be high-risk for the buyer. The transaction fee is likely to be deeply discounted due to the high risk to the buyer.
Clarification: You can sell an asset for the purpose of realizing a loss. Tax-loss harvesting (in securities, at least) is a real thing. Even a business may sell an asset no longer used to realize a loss. That is still a bona fide business transaction since it is reasonable for a business to sell an unproductive asset.
Since the seller is only interested in the tax loss and assuming the original purchase was made as an investment, sham transaction doctrine issues are easily avoided.
That still leaves us with the price. It is easy to see where a wallet worth potentially $10,000 might sell for $500 or even less. The seller can’t access the asset and the buyer is hoping the asset is available to sell in the near future and that the underlying asset market price is still reasonably high for a profit. But what about very large accounts? I saw an investor with a personal wallet worth seven figures he couldn’t access due to a lost password. Is it reasonable for a buyer to pay $50,000 for such a high-risk asset? Or is $1,000 a reasonable price to complete the transaction?
I don’t think price is the issue as long as it is a transaction between two disinterested parties. That is how price is determined. Two sides decide on what they will sell/buy the asset for.
The sham transaction doctrine should not be an issue for most transactions of distressed crypto. I only wanted you to keep the issue in mind when planning a sale in case issues arise.
Substance Over Form Doctrine
This doctrine needs to be considered before the sale of distressed crypto is made.
The substance over form doctrine says that a transaction needs to have economic substance over merely the legal form in determining the true nature of the transaction.
Distressed assets sell at deeply discounted prices. This is a known fact. Distressed crypto will likewise sell at a deeply discounted price. Still, effort must be made to assure the economic substance of the transaction reflects the true nature of the transaction.
Charge-off receivables (delinquent bank loans) have an active market. Prices vary by the degree the debt is out from the last payment. Distressed crypto still needs to develop a market to find a price range for the variety of distressed crypto.
Just as with charge-off receivables, distressed crypto should be treated the same way for tax purposes. However, charge-off receivables are almost always part of a business transaction. The question: Is distressed crypto an asset sale to an investor or a business transaction? Charge-off receivables are generally purchased as inventory by a business entity with active collection actions quickly following. With distressed crypto action to free the underlying asset value is likely to be undertaken by the buyer. That means the buyer may be a business rather than an investor. The buyer will be taxed accordingly. The difference between a business and an investor will come down to facts and circumstances: how many distressed purchases made, actions taken to collect on the asset, etc.
Selling to a Friend
As I started to see some of these distressed crypto issues enter my tax office I had an idea. My thought was that I could buy the distressed crypto at a nominal price and charge the client a fee for the service. I ran the idea past my legal team.
I picked up on the related-party rules and arm’s length transaction right away. Where the issues arose was with the numerous doctrines.
Selling to family was out. What about selling to a friend? What if the friend is not an investor but is willing to buy your distressed crypto for a fraction of a cent on the dollar? Is this a “real” transaction? Or does it run afoul of the doctrines listed above.
Attorney Lisa Burns at Wagner, Falconer & Judd, Ltd helped me sift through the issues. She discussed my ideas with her legal peers in her office. After a long conversation it was felt that a sale of distressed crypto via a legal exchange would be allowed for tax purposes, freeing the loss to be claimed as a deduction. (Facts and circumstances will vary so it is vital that you consult with a qualified legal professional and qualified tax professional before conducting a transaction of distressed crypto.)
After my discussion with attorney Burns more questions came to mind. Where is the line between investor and business? It makes a difference. Buying distressed crypto has the potential of being big business, and a profitable one at that. A lot of money is potentially on the line. However, the risks are extraordinarily high. Always consult with legal and tax professionals on your specific situation before conducting a transaction.
If selling is not an option or you are uncomfortable selling, you still have another out.
When you deliberately give up possession and ownership of a property, discontinue use of the property without transferring title to an entity or person, you may have an abandonment loss. (§165(a) allows a tax deduction from abandonment losses without actually mentioning abandonment.)
There are numerous Tax Court rulings on abandonment. Unfortunately, cryptocurrencies are new and yet to be clearly defined by the Tax Court for abandonment issues. Regulations have provided more guidance for reporting sales of crypto, but new issues with distressed crypto are yet to be fully addressed.
The Tax Court has often used a three-prong test in determining if an asset is abandoned, and thus a deduction for losses allowed. Let’s review the prongs:
- Ownership of the property prior to abandonment
- An intent to abandon the property
- Affirmative action to abandon the property
An abandonment loss under §1.165-2 of the tax code is:
“a loss incurred in a business or in a transaction entered into for profit and arising from the sudden termination of the usefulness in such business or transaction of any non-depreciable property, in a case where such business or transaction is discontinued or where such property is permanently discarded from use therein, shall be allowed as a deduction under section 165(a) for the taxable year in which the loss is actually sustained.”
We need to answer the questions posed by §1.165-2:
Did you enter the transaction for profit?
This could be the biggest issue with crypto abandonment. Crypto investors claimed crypto would replace traditional money. So was the original crypto purchase an investment with an intent for profit or just an exchange of money to be used for future purchases of goods and services? Was there really a profit motive?
It appears that most investors used the money replacement as an excuse to add perceived value to crypto. In reality, most purchasers of crypto did not use the currency to purchase goods and services, but rather as an investment, with a profit motive.
Sudden termination of usefulness?
A personal crypto wallet with lost password fits the bills. Unfortunately, it will be difficult to prove you took “affirmative action to abandon the property.” A lost wallet password may only afford the sale option above.
Exchanges that suspended transactions and/or distributions also seem to satisfy this parameter. However, this still has “affirmative action” issues.
All crypto is non-depreciable so no problems here with abandonment.
Permanently discarded from use?
It is important to keep records of each of these steps in case the IRS questions the deduction. Permanent discard can be handled by sending the crypto to a null address.
Do not confuse a vanity address with a null address. A vanity address is an address you set up with numbers and letters chosen by you. A null address receives coins and removes them from circulation forever. You no longer own the coin once transferred to the null address. Example of a null address.
Of course, you still need the ability to transfer the crypto to the null address. If this is not possible the only option is sale of the asset as described above.
Abandonment offers a better deal on your tax return. Abandonment losses are reported on line 10 of Form 4797, as an ordinary loss. Losses from a sale end up on Form 8949, flowing to Schedule D and then the 1040. Losses on Schedule D are limited to other capital gains and up to $3,000 against other income.
Nonbusiness Bad Debt
There is one last option some non-tax sites (such as CNBC) are proposing and that probably will not work: the nonbusiness bad debt.
Many crypto investors invested their money into exchanges offering high returns similar to a savings account. The argument is that this is really a loan to the exchange and not an investment.
The problem is that a nonbusiness bad debt needs to be worthless. Completely worthless!
Funds on exchanges doubtfully fall into this category. All attempts at collection need to be made before a nonbusiness debt is considered bad. If the debt is discharged in bankruptcy then this option comes into play.
Also, a lost password on a personal wallet also in not a nonbusiness bad debt. You just forgot the password with really bad results; you can’t access your crypto.
Deducting crypto losses from exchanges shut down or suspending distributions is getting common. Many claim the solution is a personal wallet not held on an exchange. There are a few people that contacted my office with lost password issues. It seems crypto can be “lost” just like any other form of money. Deducting these losses are a challenge.
In all cases, this is an evolving tax issue. If you have a crypto tax issue not listed above, leave me a note in the comments. I will try to give an answer. Give me a few days as I may need to consult with my legal team before responding. Also, comment if you have an expansion of anything I discuss above.