No loss deduction from drastic drop in digital asset’s value

The IRS Office of Chief Counsel (OCC) concluded in a Chief Counsel Advice memorandum (CCA) that a significant decrease in the value of units of a digital asset did not result in a loss deduction under Sec. 165, since the units were not deemed worthless or abandoned.

The taxpayer, an individual, purchased units of a digital asset for $1 each in 2022 on a cryptocurrency exchange for personal investment purposes. The per-unit value of the digital asset subsequently fell to less than 1 cent by the end of 2022.

As of Dec. 31, 2022, the digital asset continued to be traded on at least one cryptocurrency exchange. According to a footnote in the CCA, as of Jan. 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.”h The taxpayer also continued to maintain dominion and control over the units, as evidenced by the fact that the taxpayer was still able to sell or otherwise dispose of them.

On a 2022 individual income tax return, the taxpayer took the position that the units were worthless or abandoned and took a loss deduction under Sec. 165.

Under Sec. 6045(g)(3)(D), digital assets are defined as “digital representations of value that are recorded on a cryptographically secured distributed ledger.” These assets, which are not limited to property, do not exist physically and have previously been referred to by the IRS as “convertible virtual currency and cryptocurrency” (Notice 2014-21). Notice 2014-21 also states that convertible virtual currency is treated as property and subject to general tax principles applicable to property transactions.

Sec. 165(a) provides a deduction for any losses sustained during the tax year that are not compensated for by insurance or otherwise. The loss must be “evidenced by closed and completed transactions and as fixed by identifiable events occurring in such taxable year” (Regs. Sec. 1.165-1(d) (1) ). If a capital asset, such as a security, is deemed worthless, it will be treated as a sale or other disposition of a capital asset (Sec. 165(g)). However, the OCC advised that the digital asset discussed in the CCA did not rise to the level of a security under Sec.165(g)(2).

For individual taxpayers, Sec. 67(b)(3) characterizes Sec. 165(a) losses other than those from casualty, theft, and wagering as miscellaneous itemized deductions subject to the floor of 2% of adjusted gross income. Sec. 67(g), however, suspends these itemized deductions as a result of the law known as the Tax Cuts and Jobs Act, P.L. 115-97, for tax years beginning after Dec. 31, 2017, and before Jan. 1, 2026.

Even though the taxpayer’s units of the digital asset decreased in value, their value was still above zero, and the digital asset was still trading on at least one cryptocurrency exchange. Furthermore, the taxpayer did not sell or otherwise dispose of the units. In Lakewood Associates, 109 T.C. 450 (1997), the Tax Court held that “the mere diminution in value of property does not create a deductible loss.” An economic loss in value must be determined by a “permanent closing” of the transaction by an affirmative step that fixes the loss, such as abandonment, sale, or exchange (id.; see also Regs. Sec. 1.165-1). Therefore, a loss is sustained if it is “realized by a completed transaction determining its amount” and not by the mere fluctuation in value of the property (Higgins v. Smith, 308 U.S. 473 (1940); White Dental Mfg. Co., 274 U.S. 398 (1927)).

A loss may also be sustained when a digital asset becomes worthless during the year, resulting in an “identifiable event” (Regs. Sec. 1.165-1(d)(1)). Whether such an event occurs is a matter of fact (Boehm, 326 U.S. 287 (1945)). Where title is not relinquished, there must be a “subjective determination of worthlessness … coupled with a showing that the asset … is in fact essentially valueless” (Echols, 935 F. 2d 703 (5th Cir. 1991)). In Morton, 38 B. T.A. 1270 (1938), the court determined that the ultimate value of stock depends 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 values, according to the Morton court, must be negated before the loss can be fixed. In this case, the digital asset still had some value at the end of the tax year and was still being traded. Therefore, the OCC concluded that the units could possibly increase in value in the future.

To prove property has been abandoned, the taxpayer must show, based on the facts and circumstances, (1) an intention to abandon the property and (2) an affirmative act of abandonment (see Massey-Ferguson, Inc. 59 T.C. 220, 225 (1972), citing Boston Elevated Railway Co., 16 T.C. 1084, 1108 (1951), aff’d, 196 F.2d 923 (1st Cir. 1952) ). The OCC found in the CCA that the taxpayer continued to exert dominion and control over the units and was still able to sell or otherwise dispose of them. As a result, regardless of the taxpayer’s intent, there was no affirmative step to abandon the property, and consequently the taxpayer did not abandon it.

The OCC concluded that since the digital asset was not worthless and was not abandoned or otherwise disposed of by the taxpayer, Sec. 165 and its regulations did not apply, and the taxpayer did not have a deductible loss. It also determined that even if the units rose to the level of being worthless or abandoned, the loss would have still been disallowed, since miscellaneous itemized deductions subject to the 2% floor have been suspended for tax years 2018 through 2025.

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— Matthew Geiszler is a lecturer in accounting in the Brooks School of Public Policy; John McKinley is a professor of the practice in accounting and taxation in the SC Johnson College of Business; and Austin Arnold is a lecturer in taxation and financial literacy in the Cornell Law School, all at Cornell University in Ithaca, N.Y. To comment on this column, contact Paul Bonner, the JofA‘s tax editor.