Digital asset playbook: Part 2 — The loss ledger

The tax treatment for digital asset losses can be a complex area. Not to mention, misleading information can cause confusion for tax practitioners and taxpayers alike. Learn more about the intricacies of how realized digital asset losses are reported and why it likely makes sense to avoid having the digital asset be considered worthless or abandoned based on the current tax treatment. 

AICPA resources

• Digital assets and virtual currency tax guidance and resources —This hub is your go-to library for AICPA guidance and resources as well as current legislation, IRS initiatives and tax advocacy project
• Crypto loss tax reporting fact or fiction — With the prevalence of recent virtual currency exchange bankruptcies and digital asset volatility, taxpayers may have misconceptions on reporting tax losses. 
• AICPA comments on digital currency losses, April 14, 2023

Other resources 

• IRS Chief Counsel Advice (CCA) 202302011 — Memorandum that addresses the applicability of IRS Sec. 165 to cryptocurrency that has declined in value 
• IRS Digital Assets  — Resources and guidance available on the IRS.gov website

Transcript

April Walker: Hello everyone and welcome to the AICPA's Tax Section Odyssey podcast. Where we offer thought leadership on all things tax facing the profession. I'm April Walker, a lead manager from the Tax Section, and I'm here today with Annette Nellen. Annette is a professor and director of the MST program at San Jose State University. She's also a wonderful AICPA volunteer and has been on the podcast before. Welcome back, Annette.

Annette Nellen: Thank you.

Walker: This episode is Part 2 in a three-part series that we're focusing on digital assets here on the Tax Section Odyssey, a journey through digital assets, if you will.

Today's episode is going to focus on a common question that we get in this space, and that is how our losses on digital assets treated for tax purposes. A second underlying question as you're listening to this might be, what are the misconceptions? What are the things that you hear people saying…you read on the Internet about this topic that might or might not be correct.

Annette is going to really help us dig in to those. Annette let's start off at a basic level and remind our listeners, just basic digital asset 101. What do we know about digital assets in general, and what does that mean for the treatment of digital asset losses?

Nellen: Well, thank you April, the key guidance here came out in 2014. That is [IRS] Notice 2014-21, where the takeaway was digital assets. That notice actually just talks about convertible virtual currency. That is before we were using the term digital assets because that was actually added to the law in November 2021 with the infrastructure investment and jobs act.

But the notice talks about treat this virtual currency cryptocurrency treated as property. It is not treated as foreign currency for tax purposes. They answered several questions in the notice. Some were pretty obvious like if you're paid by your employer in a virtual currency, is that taxable? Yes, of course it's taxable. That's fair market value at the time they receive it.

But the key takeaway and what they said [if] something isn't addressed here. Basically go to the rules on the taxation of property transactions and that probably will answer your questions. Now it doesn't always because there are some unique features of how virtual currency, digital assets operate that other ones do not operate in that way.

For example, a virtual currency could have something called a hard fork. I'm not aware of any other property that really has a hard fork with something just breaks off from it and continues on its own. Doesn't have a good analogy there. We do occasionally run into situations where [it’s] not real clear.

That's a lot of ones where the AICPA Digital Asset Tax Task Force is trying to address those and seeking guidance from the IRS if they can point out. Because this is a question people have, what do you think the answer is? We can all be on the same page here.

Walker: Yeah, that brings up several good topics. I generally have converted to saying digital assets. We can also say virtual currency. We could say cryptocurrency, all of those being, at least in general, the same thing. If Annette says a different word or I say a different word, that's all what we're meaning.

Then also that there's some really tricky things that can happen with this type of property that's way different than some of the really complex investment type property. That's why we have to be on top of this and learn.

That was our message in Part 1. We cannot escape this. We can't just bury our head in the sand and pretend like it doesn't exist.

Annette let's take this a step further. What if a client comes to you and says, I had digital assets. This is probably a pretty common thing that happened in 2023. “I had these digital assets in this wallet and it dropped tremendously in value — like right now it's only worth $0.30 or something like that. Did I have a realized loss? And if so, how do I treat that realized loss?

Nellen: Well, that is a good question. It seems to be one that the IRS was getting as well because in January of 2023, they issued a Chief Counsel Advice 202302011. It had a few reminders in there, but doesn't address every type of loss that people might encounter with their digital assets or cryptocurrency.

The fact pattern at Chief Counsel Advice was that the person had purchased a cryptocurrency at $1 per unit, and by the end of the year, it was trading for less than $0.01. That's something also unique about this virtual currency or cryptocurrency. It can certainly be trading for far less than one penny. That itself raises an interesting question because tax we're usually rounding everything up to $1. If something's worth less than a penny, does that mean it's worthless? Probably not.

Now, in that fact pattern though, where that cryptocurrency had dropped to below $0.01 It also was still, of course, owned by the taxpayer. They hadn't done anything to have a realization event. It was still actually being traded on at least one cryptocurrency exchange. It was still possible that they could have sold that in what would have been actually an on chain transaction.

Now, the Chief Counsel Advice does not go into doesn't matter if you sell it on chain, meaning you go through the normal like the blockchain transaction, actually get that completely transferred to somebody else versus I had the code for this. I'll write it down on the piece of paper and sell it to somebody. But then technically you still arguably have the code. You could have even memorized it. It didn't go into that, but it did state that with this fact pattern — worth less than a penny, you still owned it and it was still traded at least one exchange, you did not have a realized loss. They also said it wasn't worthless and that arguably makes sense. It's not worthless because you could still actually trade it. There's some place you could get somebody to buy that from you. Of course it's not abandoned, you actually still own it.

This Chief Counsel Advice did tell us that it's not a realization event, you don't have a loss. It does talk a little bit about the general rules on worthlessness and abandonment, but it doesn't talk about how would you know if a cryptocurrency had become worthless? How do you abandon a cryptocurrency? But I do want to state and I'll probably state this more than once.

Today, you don't want to have worthless or abandoned cryptocurrency because that results in an ordinary loss because there's no sale or exchange of a capital asset. You don't have a capital gain or loss, you have an ordinary loss.

But remember deductions and losses are matter of legislative grace. If you can't point to a code section allowing you to claim that loss, you cannot claim it. If you look at Code Section 62, 63, and 67(g) and this Chief Counsel Advice highlights Section 67(g). The only place this loss, if you did have a worthless or abandonment loss on the cryptocurrency, the only place it would fall would be as a miscellaneous itemized deductions subject to 2% of AGI limit — which for 2018-2025 is not allowed at all. The taxpayer would have been better off selling that before it became worthless so that you at least have a capital loss on that. So, a lot in that answer there.

Walker: It was a lot to unpack there. A lot of times I feel like I think when you're thinking back on worthlessness and whether something has been abandoned, a lot of times people want to convert it from a capital loss to an ordinary loss. That's generally where they're going with this. But that's really not the case in this scenario, at least that was presented in the chief counsel.

Nellen: Another thing to bear in mind here is that while you think, if I had worthless securities, I get a capital loss on that. That's because there's a special rule at Code Section 165(g). Maybe just a quick review of a few more code sections. What is a capital gain or loss? That's defined at Code Section 1222. Two key things you need for a capital gain or loss is a sale or exchange of a capital asset.

Now, if you're holding cryptocurrency for an investment, yes, that's a capital asset, but abandonment and worthlessness are not a sale or exchange. It's not a capital loss. It'd be an ordinary loss. What makes worthless or abandoned securities a capital loss is Code Section 165(g). But it's limited to securities, where it says, if you have worthless securities, treat it as if you had a sale or exchange on the last day of the year, that's what's then causing you to have sale or exchange of a capital asset producing that loss for you.

Then the Regs under [Section] 165 note that abandonment is the same treatment as the worthlessness, but the cryptocurrency is not a security. I know people say, oh, but look at the head of the SEC is saying all of it's pretty much a security. That is not necessarily true for. I don’t know about securities law, but that's not the definition for tax purposes here. You're ending up with an ordinary loss.

Then I've seen on web pages and among practitioners, oh, ordinary loss, great. We claim that above the line. Now again, you saw the point to a code section. Again, if you go through Code Section 62 defining adjusted gross income, Code Section 63 and 67, really defining taxable income and allowable deductions. There's no place where it falls other than it's a miscellaneous itemized deductions subject to 2% of AGI limitation, which actually is still allowed in California. California never conformed to that, but for federal purposes, and probably most states [in] 2018-2025, that loss is not allowed.

Also just odd stuff out there as well. There are some websites, at least the ones I've looked at, it says right at the top, worthless cryptocurrency. We will take it and they'll take it for some set amount, which is a fraction of a penny. But it's troubling that they're saying at the top of the website, worthless. Now if it's really worthless, why are they giving you anything for it and that you're arguably already having a transaction with the person.

Probably that does generate a capital loss from the sale or exchange of that. That'd be an example where it'd be nice if the IRS could say, even though you didn't negotiate the price, because that website is going to give everybody the same fraction of a penny for your "worthless". But again, it's arguably not worthless as I'm taking it from you. But that'd be viewed as a valid sale or exchange. We didn't negotiate the price, but again, we're talking about a price for something is worth less than a penny, would they ever come back and say, hey, if that's the main feature, just worth less than a penny, it's worthless.

In the letter that we sent off, the Digital Asset Tax Taskforce, we sent off a letter in April 2023. The Chief Counsel Advice is quite helpful, but it doesn't address everything. If one of the things that we asked was could you tell us what you think would indicate that a cryptocurrency is worthless and how you could actually abandon a virtual currency? Because then taxpayers would know how to avoid those situations, because that's not an ideal tax result for an investor.

Walker: Those are some great points and like you said, I will definitely put the chief counsel memorandum in there and also some of the letters that the Digital Asset Tax Taskforce has done and continues to do. While we're on that topic, let's talk about some more things that we might have done around digital asset losses. You do reference that letter and we'll put that in there and other guidance that's needed.

Referring back to that website I guess they're probably not saying worthless as in worthless for tax purposes. Maybe that's where they're going with that. But still it's very misleading for consumers as well as probably for tax practitioners who might not operate in this space.

Nellen: The taxpayer who's done that [and] transferred it there. I believe that actually is an on chain transactions, so that's good because that's indicating there was some way you still could transfer it.

Because one of the questions we've asked the IRS, both on the letter and when we occasionally meet with them is, what if it's the blockchain is down, nobody's verifying these transactions on X coin because it's over 9,000 virtual currencies out there. Maybe one just seems to be gone, you can't transfer anything. Would that indicate it's now worthless, because maybe sometime in the future, it'll get reactivated. Plus probably if you had the code on a piece of paper, there's somebody out that it will probably buy it from you for five dollars or something just to say, hey, maybe it will go back into business. Which is why I think these websites are taking all these things that people think are worthless, which clearly aren't worthless, somebody's making a market for these items.

Would that be a permissible transfer when it wasn't on chain. Just I wrote down the code, but arguably do I still have access to the code and then had convinced the buyer [that] I [have] erased it from my mind. I've burned the piece of paper and any other place I wrote it down. That's another topic that I hope the IRS will address it some time because it’s also relevant if you're gifting virtual currency to your relative. Do you have to do it on chain to make sure it's a valid transaction that everybody would know. Yes, it’s on the blockchain that just got transferred and you no longer have any access to it at all, only the recipient.

I would certainly say if you're going to make a gift to somebody, do it on chain, that's more likely should be a valid gift because you relinquish every ability to access that. But these are examples that come up. But it would be nice if the IRS could tell us what would make something worthless, what would make a cryptocurrency abandoned.

But I do hear from practitioners, so someone trying to do that because they think this ordinary loss that I can claim against my wage income and other income, that's not the case. I will encourage you to take a look at the chief counsel advice in the code sections it's referring to and we have an analysis of that in the letter as well.

But it does get confusing because people might just do a Google search and come across things that sound convincing. But remember, we're respected practitioners, we need to be looking at the law itself. Is that any support for this answer in the law itself?

Another code section we raised in the letter, erase a variety of things. Could you address this issue? There's a Code Section 1234(A), which we don't see many cases on, but occasionally we do. Where it's basically saying certain terminations of a right to a capital asset would be treated as a sale or exchange, then giving you that capital gain or loss situation. What is a termination of a cryptocurrency? The fact that the blockchain is no longer having transactions and nobody is verifying these. The blockchain has somehow been destroyed and I guess you destroy all the software or something. Would that be enough?

Then you also have the issue of what about the part that is dealing with their right to a capital asset. Is that what cryptocurrency could be defined as?

We've also raised the question, well, what about lending digital assets? Because the word lending and then digital assets. If we're thinking about currency, we're lending currency. But remember, the Notice 2014-21 said that the cryptocurrency/virtual currency is not treated as currency for tax purposes, it's treated as property. It's like you're lending your car to somebody. What happens if it doesn't get returned?

Also, what about the income you're generating from that [digital asset]. Is that portfolio [or] is it a trade or business? Obviously relevant for passive activity loss purposes under [Section] 469 and a variety of other issues.

These are tough issues for the IRS to deal with as well and have the magic answer. They're doing research, but some places it might be that maybe you just need to have a position. Hey, if this happens, we would treat this virtual currency as worthless, then we would all be on the same page at least of how that is viewed. Then we also in our letters, always make the statement or asking for guidance. We'd like to have binding guidance like a revenue ruling, revenue procedure, regulations. A chief counsel advice unfortunately, it's not binding guidance. Of course, the law [code] sections and there's all citing to binding guidance code, regs, court cases, things like that.

Walker: FAQs they did a round of those.

Nellen: But some of them are just restating binding law. But there were a few in there that were new.

Walker: I think some of the terminology also gets mixed up in there too, and that's part of the clarification in the letters. This has been really helpful Annette. I feel like sometimes we come out of this with more questions or I do, with more questions than answers, but at least you've got us pointing to asking the right question around us as we're looking to do 2023 returns that have this digital asset activity. Any final thoughts that you want to leave us with on this topic?

Nellen: I encourage you with losses, do take a look at that chief counsel advice [memorandum], the letter that the digital asset tax taskforce prepared and some of these comment letters — plenty of ones from the AICPA, New York State Bar and the ABA often have a lot of background information as well. Because it's not always a lot of information out there tax-wise on these on what are relatively still new transactions you've been around since about 2009.

When again, always remember we need to go to the primary authority for determining what is the tax treatment of something because there's a lot of misinformation out there. Unfortunaty also from accountants and attorneys. Sometimes they're just saying a statement that they haven't really dug into or they don't really know enough about the digital assets to realize that there is something different out there. Or they forgotten about Code Section 1222 or things like that. But the taskforce continues to look at what is going to help AICPA members to deal effectively with their clients? Where could we benefit from more binding information from the IRS?

Walker: We're wrapping up and closing on these podcasts I like to talk about us taking a journey. We're taking a journey through digital assets. We're just taking a journey towards a better profession, or that is my goal. But I like to hear about my guests other journeys outside of tax. Annette, you have been on here before. But tell us a trip you have planned or a trip you have been on recently that was memorable.

Nellen: Memorable would be right before Christmas, I did take my daughter, son-in-law, 9 year old grandchild, and infant grandchild to Disneyland. That was nice experience and all that. More immediately, I get to go to the American Taxation Association, which I'll mention because most members probably don't know but that, but that's a very large group of primarily tax professors and a few folks from accounting firms. We are having our mid-year meeting down in Long Beach where I've a couple of presentations with the AICPA.

Walker: Nice. Anytime a beach is involved, I'm always like yes, please. Even if it involves also some works stuff. Great. Thank you again Annette for this very helpful walk-through digital assets, virtual currency, cryptocurrency losses.

Again this is April Walker from the AICPA Tax Section. This community is your go-to source for technical guidance and resources designed especially for CPA tax practitioners like you in mind. This is a podcast from AICPA and CIMA together as the Association of International Certified Professional Accountants. You can find us wherever you listened to your podcast and we encourage you to follow us so you don't miss an episode. If you already follow us thank you so much and please feel free to share with a like-minded friend. You can also find this at aicpa-cima.com/tax, and find our other episodes as well as get access to the resources that we mentioned on this episode and others. Thank you.

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