Understanding the etymology of a word often enables us to better understand or appreciate its use in contemporary speech. For example, the word “crypto” is derived from the Greek word “krypto,” which describes something that is hidden or concealed.[i]
For many months now, cryptocurrency – “crypto” for short – has received a lot of attention in the media,[ii] none of it favorable. Indeed, many of the stars in the crypto firmament have recently burnt out and fallen,[iii] and others are certain to follow.[iv]
According to at least one observer, “2022 marked the start of a new ‘crypto winter,’ with high-profile companies collapsing across the board and prices of digital currencies crashing spectacularly.”[v]
Based upon this dismal performance and the financial revelations that have accompanied it, one can understand why federal regulators have been so suspicious of anyone touting the positive traits of such a so-called “currency.”
Evolution or . . .
Originally, currency was issued in the form of coins made out of a precious metal (like gold), so that the coin itself was inherently valuable.[vi]
Later, currency was made out of paper that, in itself, was worthless but which was physically easier to handle. This paper, or banknote, was, and continues to be, a bearer note – meaning that its “value” is not “payable” to a specified person, but rather to whomever holds it – that is issued only by the government’s central bank.[vii]
The paper’s status as a bearer note – “cash,” in the colloquial – affords the persons who transact business using such notes a degree of anonymity and, with that, the ability to avoid their lawful tax obligations. After all, it is relatively difficult to trace cash and relatively easy to hide it.
It used to be that paper banknotes were backed by gold – meaning that the banknote could be presented to the government’s central bank and exchanged for gold[viii] – but that is no longer the case.
Today, your ordinary dollar bill and its siblings are backed by the “full faith and credit” of the U.S.,[ix] which seems to satisfy most of the world. These banknotes represent “legal tender” that a vendor of property or services is legally obligated to accept in satisfaction of the debt created in connection with such a sale.
. . . Degeneration? A Layperson’s Understanding[x]
Like “real” currency,[xi] virtual currency acts as a medium of exchange for purchasing goods and services; as such, it can circulate from person to person, much as real currency does. Also, like real currency, it can exist in different units of value.[xii]
Unlike real currency, crypto is not issued by a national government or its central bank; it is not legal tender that must be accepted by someone selling goods or services within a particular jurisdiction. What’s more, it does not exist in any tangible form (like paper money), but only electronically.
Its proponents claim that, because virtual currency is not controlled by a central bank, it is free from interference by any such institution. They also claim that it may be transferred between parties to a transaction[xiii] without incurring the high fees often charged by traditional financial institutions. In addition, the software that is used to effectuate these transfers functions without the need for the “identifying information” of the parties, thus providing a degree of anonymity.[xiv]
I can’t comment on whether these “advantages” do, in fact, exist.
I will observe, however, from a theoretical perspective, that both the real and virtual systems depend upon the maintenance of a data base for each user, one that records the user’s transactions in which the real or virtual currency is acquired or transferred. In the case of real currency, a central bank handles this function; in the case of virtual currency, the function is performed by many private persons through a process called “mining,” which seeks to maintain the integrity of the “system” by validating transactions between parties.[xv]
The IRS and “Crypto”
The IRS did not issue guidance regarding the treatment of crypto for tax purposes until 2014.[xvi]
At that time, the IRS limited its guidance to virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency (so-called “convertible” virtual currency).[xvii]
General Tax Principles
According to the IRS, virtual currency is treated as “property” for federal tax purposes; consequently, “general tax principles” applicable to property transactions apply to transactions using virtual currency.
For example, a taxpayer who receives virtual currency as payment for goods or services must, in computing their gross income, include in their gross income the fair market value of the virtual currency, measured in U.S. dollars, as of the date that the virtual currency was received. This amount also represents the initial basis of such virtual currency in the hands of the taxpayer.[xviii]
If the fair market value of property received in exchange for virtual currency exceeds the taxpayer’s adjusted basis for the virtual currency,[xix] the taxpayer has taxable gain.[xx] This should be compared to legal tender – like the dollar – which is always worth its face value, and the basis of which is also equal to its face amount.[xxi]
The character of the gain from a sale of crypto generally depends on whether the virtual currency is a capital asset in the hands of the taxpayer. A taxpayer generally realizes capital gain on the sale or exchange of virtual currency that is a capital asset in the hands of the taxpayer. A taxpayer generally realizes ordinary gain on the sale or exchange of virtual currency that is not a capital asset in the hands of the taxpayer.
More recently, the IRS issued forty-six FAQs that expand upon the guidance provided in 2014 but still rely upon the same “longstanding tax principles” applicable to property transactions.[xxii]
For example, the FAQs explain how to determine one’s basis and holding period in crypto, the amount of income one recognizes when paid in crypto, and the amount of gain one recognizes when paying someone else in crypto or when exchanging other property for crypto.
Significantly, the FAQs apply only to taxpayers who hold virtual currency as a capital asset. Thus, one FAQ asks whether a taxpayer who sells virtual currency must recognize any capital loss or gain on the sale? In response, the FAQ states that the selling taxpayer must recognize any capital gain or loss on the sale, subject to any limitations on the deductibility of capital losses.
Speaking of losses, the IRS’s Office of Chief Counsel (“OCC”) last week issued a Chief Counsel Advice (“CCA”) regarding the tax treatment under the Code of cryptocurrency that has declined in value.[xxiii]
Specifically, the CCA discussed the case of a taxpayer (“A”) who owns cryptocurrency that has substantially declined in value. The CCA considered whether Taxpayer A sustained a loss due to the worthlessness or abandonment of the crypto for which they may claim a tax deduction.
The OCC began by stating that the Code allows a deduction for losses that are (i) evidenced by closed and completed transactions, (ii) fixed by identifiable events, and (iii) actually sustained during the taxable year.
However, under the circumstances described below, the OCC concluded that Taxpayer A did not abandon or otherwise dispose of their crypto, and that the crypto was not worthless because it still had value. Therefore, Taxpayer A did not sustain a deductible loss.[xxiv]
Taxpayer A was 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 their units of Cryptocurrency B, as evidenced by Taxpayer A’s ability to sell, exchange, or transfer the units.
Taxpayer A plans to claim a deduction on their 2022 tax return[xxv] based on the position that the units of Cryptocurrency B became worthless or were abandoned during 2022.
The CCA explained that “digital assets” are defined under the Code[xxvi] as “digital representations of value that are recorded on a cryptographically secured distributed ledger.”[xxvii]
Digital assets, the CCA continued, “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.” Referring to the IRS’s 2014 guidance (see above), the CCA stated that convertible virtual currency is treated as property and that “general tax principles applicable to property transactions apply to convertible virtual currency.”
According to the CCA, 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, the CCA states, 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 (a “dealer”) 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.
The Code allows a deduction for losses sustained during the taxable year and not compensated for by insurance or otherwise.[xxviii] A loss is allowed as a deduction 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.[xxix]
The Code also 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.[xxx]
A “security” is defined, for this purpose, 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.[xxxi]
Cryptocurrency B, the CCA determined, is none of the items listed above; thus, it is not a security for which a deduction based on worthlessness may be claimed.[xxxii]
The CCA conceded that Cryptocurrency B substantially decreased in value since its acquisition by Taxpayer A. The CCA pointed out, however, that its value was greater than zero, it continued to be traded on at least one cryptocurrency exchange, and Taxpayer 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.”[xxxiv]
A loss may be sustained, however, if a cryptocurrency becomes worthless, resulting in an identifiable event that occurs during the tax year. Whether an asset has become worthless is a question of fact. 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.” In making such a determination, the ultimate value of a crypto, and conversely its worthlessness, “will depend not only on its current liquidating value,” but also on what value it may foreseeably acquire in the future (its potential future value). “Both factors of value must be wiped out before we can definitively fix the loss.”
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.[xxxv] 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.
The CCA then turned to Taxpayer A’s claim that they had abandoned their units of Cryptocurrency B.
The CCA explained that a taxpayer sustains a loss 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.”[xxxvi]
According to the CCA, Taxpayer A did not take any action to abandon and permanently discard Taxpayer A’s units of Cryptocurrency B during 2022. Abandonment, it stated, 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. “The mere intention alone to abandon is not, nor is non-use alone, sufficient to accomplish abandonment.”
Some express manifestation of abandonment is required when the asset is an intangible property interest. 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 in 2022 due to abandonment.
The IRS has been approaching the tax treatment of crypto slowly and methodically, as it should, notwithstanding what some have decried as a dearth of guidance.
In the meantime, the IRS presumably will rely on its not insignificant administrative, interpretive and enforcement powers, coupled with “general tax principles,” to monitor and determine the tax consequences of cryptocurrency transactions, as it did in the CCA described above.
In addition, the IRS’s Virtual Currency Compliance campaign[xxxvii] will continue to address noncompliance related to the use of virtual currency through outreach and examinations.
Speaking of examinations, it would behoove taxpayers with unreported virtual currency transactions to correct their returns as soon as practicable. The IRS has stated clearly that it is not contemplating a voluntary disclosure program to address tax non-compliance involving virtual currency – this may be taken as a sign of how the IRS perceives the magnitude of the threat to tax revenues that is presented by cryptocurrency transactions.
Stay tuned. More guidance may be forthcoming this year in light of the crypto losses experienced in 2022.
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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
[i] The word has always had a negative connotation in my mind.
[ii] You have to appreciate the irony of crypto’s very public decline.
[iv] Crypto broker Genesis is said to be preparing to file for bankruptcy this week. https://www.ft.com/content/2a163bd2-3cd3-4869-bfc0-c0364eb27937.
[vi] “Valuable” in that someone was willing to give up something they had in exchange for the coin.
[vii] The Federal Reserve Bank, in the U.S.
[viii] Before 1971, paper money included the following statement: “This note is legal tender for all debts, public and private, and is redeemable in lawful money at the United States Treasury or at any Federal Reserve Bank.”
“Lawful money?” Gold.
[ix] Take a look at the paper money in your pocket or wallet, assuming you still carry any. It includes the following statement: “This Note Is Legal Tender for All Debts, Public and Private.” It is no longer redeemable for money.
In 1971, President Nixon eliminated the convertibility of the dollar into gold. One of the reasons for doing so was to prevent foreign governments from exchanging the dollars held by their central banks for the U.S.’s gold reserves.
[xi] For example, U.S. dollars.
[xii] As I understand, these “units” or “tokens” are created by a complex computer code.
[xiii] The transfer is described as being “peer to peer.”
[xiv] Isn’t that lovely?
[xv] For example, by ensuring that the same unit of currency is not used twice in short order by the same person.
[xvi] Notice 2014-21. https://www.irs.gov/pub/irs-drop/n-14-21.pdf.
[xvii] Bitcoin is one example of a convertible virtual currency. Bitcoin can be digitally traded between users and can be purchased for, or exchanged into, U.S. dollars, Euros, and other real or virtual currencies.
[xviii] Query how such fair market value is to be determined.
[xix] To-date, the IRS has not treated virtual currency in the same way as foreign currency for purposes of IRC Sec. 988, which addresses foreign currency transactions.
[xx] Has the virtual currency appreciated in value?
[xxi] Though its value relative to other items may be different at different periods of time; for example, because of inflation. I remember when a regular slice of pizza was 25 cents. Today, that regular slice is $3.00.
[xxiii] IRS CCA 202302011, January 13, 2023.
[xxiv] 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.
[xxv] Under Sec. IRC Sec.165.
[xxvi] IRC Sec. 6045(g)(3)(D).
[xxvii] Pretty obvious, right? It gets better. The CCA later states:
“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.”
[xxviii] Section 165(a).
[xxix] Reg. Sec. 1.165-1(d)(1).
[xxx] Section 165(g).
[xxxi] IRC Sec. 165(g)(2).
[xxxii] As an aside, the CCA goes on to add that, for individual taxpayers, IRC Sec. 67(b)(3) characterizes Sec. 165(a) losses, other than those from casualty, theft, and wagering, as miscellaneous itemized deductions. Under current law, IRC Sec. 67(g) disallows all miscellaneous itemized deductions for tax years beginning after December 31, 2017, and before January 1, 2026.
[xxxiii] If you ask me, to borrow a term from the taxation of private foundations, it’s the jeopardy investment du jour.
[xxxiv] Reg. Sec. 1.165-1.
[xxxv] The CCA observed that, 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.
[xxxvi] Reg. Sec. 1.165-2(a).