Crypto Tax Loss & the Tax Loss Deduction Rules

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Crypto tax loss refers to the capital losses incurred from selling or trading cryptocurrencies at a lower price than what was paid for them. These losses can be used to offset any gains earned throughout the year, reducing the taxpayer’s overall tax bill.

The tax laws are clear that this type of investment loss is allowable. But what about other types of losses involving cryptocurrency?

Crypto losses may also be triggered by other events, such as coins becoming worthless and coins or accounts that are lost. Even transferring funds to the wrong address can trigger a loss given that transactions are irreversible. Scams are also common and can trigger losses.

The IRS recently issued CCA 202302011 which addresses losses on cryptocurrency when the holding declines in value. This provides an opportunity to consider how cryptocurrencies are taxed and when losses are allowable and how taxpayers use crypto tax losses in their tax planning.

Cryptocurrency as Property, Not Fiat Currency

The IRS’s position on cryptocurrencies is that they are treated as property for tax purposes, not as fiat currency.

This means that when you buy, sell, or trade cryptocurrencies, you must report any gains or losses on your tax return, just like you would with other types of property such as stocks or mutual funds.

The IRS issued guidance on this matter in 2014, Notice 2014-21, stating that “virtual currency is treated as property for U.S. federal tax purposes”. This means that the tax rules that apply to property transactions, such as capital gains and losses, also apply to cryptocurrency transactions.

When you sell cryptocurrency at a gain, you will owe taxes on the difference between the purchase price and the sale price. Similarly, if you sell cryptocurrency at a loss, you may be able to deduct the loss from your taxes.

Using Crypto as Currency

Given the IRS’s position on cryptocurrency being property, the use of crypto as currency can be problematic.

If you are paid in cryptocurrency for goods or services, the fair market value of the cryptocurrency on the date you received it is considered income and is subject to taxation. The income side of it makes sense. It is an increase in wealth. Section 61 of the tax code would seem to capture this increase.

The problem is not the receipt of income, but rather, the use of crypto to buy items. The party to the transaction who uses crypto to buy items is not only buying the item, but is also treated as selling their cryptocurrency at the same time. There are two transactions. For the sale of the cryptocurrency, the party buying the item has to compute their gain on the sale of the cryptocurrency. This means that the party has to know what their tax basis is in the cryptocurrency. This might be possible if the party purchased the cryptocurrency and can identify the purchase. This isn’t possible or feasible for most as they purchase and trade and exchange crypto over time, creating a web of transactions and transfers that is virtually impossible to untangle.

Computing the Tax Loss for Cryptocurrency

This brings us to the more common types of losses, i.e., an investor purchases crypto for one price and then sells the crypto for a lower price.

This brings in the standard formula for determining the taxable gain. The formula is: amount realized = amount realized – adjusted basis.

The amount realized is the sales price. That part isn’t difficult. The adjusted basis can be more difficult. The adjusted basis cost basis of the cryptocurrency. This refers to the original price at which the cryptocurrency was purchased. The cost basis is subtracted from the sale price to determine whether there was a gain or loss on the transaction.

For example, if an individual bought one Bitcoin for $20,000 and later sold it for $16,000, they would have incurred a loss of $4,000. This loss can be used to reduce their overall tax liability.

Tax Aspects of Cryptocurrency Sales

There are a few unique aspects of cryptocurrency sales. One is that the sale is treated as the sale of a capital asset. The result is that the asset is subject to lower capital gain rates and the wash sale rules do not apply.

Capital Gains in Cryptocurrency Trading

Cryptocurrency investors need to consider both short-term and long-term gains when trading cryptocurrencies.

Short-Term Gains

Short-term gains in cryptocurrency trading refer to profits made from trades that are held for less than a year. These types of trades can be very profitable, but they also come with higher risks due to the volatility of the cryptocurrency market. Short-term traders often use technical analysis and market trends to make quick decisions on when to buy and sell coins.

One example of short-term trading is day trading, which involves buying and selling cryptocurrencies within a single day. Day traders aim to profit from small price movements in the market by making multiple trades throughout the day. This type of trading requires a lot of time and attention, as well as knowledge about market trends and technical analysis.

Another example of short-term trading is swing trading, which involves holding onto coins for several days or weeks before selling them for a profit. Swing traders rely on chart patterns and other technical indicators to identify potential price movements in the market.

Long-Term Gains

Long-term gains in cryptocurrency trading refer to profits made from trades that are held for more than a year. Many investors prefer this strategy because it allows them to take advantage of potential future growth in the value of their coins.

Long-term investors often do not pay as much attention to short-term price fluctuations since they believe that over time, their investments will appreciate significantly. They may also choose not to trade frequently or at all, instead opting to hold onto their coins until they reach their desired level of profitability.

Limit on Capital Losses

While capital gain rates are nice, the corresponding treatment of capital losses is not great.

If you sell cryptocurrency at a loss, you can use that loss to offset any capital gains you may have from the sale of other investments, such as stocks or real estate. If your losses exceed your gains, you can deduct up to $3,000 of the remaining losses from your taxable income in the current tax year. You generally cannot offset your wages or other income with this type of capital loss in excess of this amount. Any losses beyond that amount can be carried over to future tax years and used to offset capital gains or deducted up to $3,000 each year until the losses are fully used up.

For example, if you sell cryptocurrency at a loss of $5,000 in a given tax year and you have no capital gains, you can deduct $3,000 from your taxable income for that year. The remaining $2,000 can be carried over to the next tax year and used to offset capital gains or deducted up to $3,000 each year until the losses are fully used up. This is true even if you have wages from your job and are paying tax in the current year on the wages.

As you can see, this can result in capital loss carryovers that cannot be used for quite some time.

No Wash Sale Concerns for Crypto: Tax Loss Harvesting

The wash sale rules are another aspect of tax on cryptocurrencies.

Wash sales occur when an investor sells a security or asset at a loss and then buys the same or substantially identical asset within 30 days before or after the sale. Our tax laws disallow the loss if this happens. This rule does not apply to crypto transactions, as crypto is considered property and not a security for tax purposes.

This opens the door for strategic tax loss harvesting. Tax loss harvesting involves selling assets at a loss to offset capital gains and reduce taxes owed. This means that if you have investments that have decreased in value since you purchased them, you can sell those investments to offset any gains you may have made elsewhere in your portfolio.

Tax loss harvesting can be particularly useful due to the volatility of the market. The cryptocurrency market is known for its rapid price fluctuations, which means that there are often opportunities for investors to realize losses that they can use for tax purposes.

One only has to consider the situation where they invest in crypto and sell another asset for a gain, such as real estate. If their cryptocurrency investment fluctuates to produce a loss, the investor can sell the crypto and immediately reinvest in it, so that they trigger a tax loss to offset the gain on the sale of their real estate. They can continue to do this every minute, hour, day, week, etc. during the year to offset the gain on the sale of the real estate.

This shifts the downside risk for crypto investments to the government, as the government is footing a large part of the bill for the harvested losses.

Challenges for Crypto Given Existing Tax Laws & Reporting

defi web3.0 tax loss

The variability and technology for cryptocurrencies and transactions pose challenges for the IRS. The rise of DeFi platforms has introduced new complexities to the taxation of cryptocurrency.

DeFi platforms operate on decentralized blockchain networks, allowing users to engage in peer-to-peer transactions without the need for intermediaries. These transactions generally cannot be tracked by tax authorities, making it difficult to determine the tax implications of using DeFi platforms.

For example, in the case of lending and borrowing on DeFi platforms, users may earn interest on their crypto holdings or pay interest on borrowed funds. This interest income or expense may be taxable, but it can be challenging to track and report these transactions to the tax authorities.

Similarly, trading on DeFi platforms may result in capital gains or losses that are subject to taxation. However, the decentralized nature of these platforms can make it difficult for users to accurately determine the cost basis of their crypto assets, which is necessary for calculating capital gains and losses.

Moreover, some DeFi platforms issue their own tokens or coins, which can create additional tax complexities. These tokens may have different tax treatment than other cryptocurrencies, and the rules for reporting income or gains from these tokens may not be well-defined.

The Tax Loss Rules

This brings us to the tax loss rules under Sections 165 and 166.

Traditional Sec. 165 Crypto Tax Losses

Section 165 provides rules for deducting losses incurred in a trade or business or in any transaction entered into for profit, including losses related to cryptocurrency.

To claim a loss deduction for cryptocurrency under section 165, the loss must be:

  1. Realized: The loss must be incurred as a result of a sale or exchange of cryptocurrency.
  2. Recognized: The loss must be recognized for tax purposes, meaning it must be reported on your tax return.
  3. Documented: You must be able to provide documentation of the transaction that resulted in the loss, such as records of the purchase and sale of the cryptocurrency.

The IRS guidance noted above addresses this fact pattern. It acknowledges that Section 165 applies to cryptocurrencies. However, it addresses a fact pattern whereby the investment declined in value, to mere pennies, and was never disposed of or abandoned. Given this fact pattern, the IRS concludes that a loss was not realized as there was no triggering event. This is one of the challenges with tax losses generally, i.e., how to document the triggering event.

The IRS guidance stops short of the more common situation where the crypto declines in value and is no longer recoverable, or the amount declines and the taxpayer takes steps to abandon the crypto.

Sec. 165(g) Crytpo Tax Loss for Worthless Securities

The IRS guidance also considers the Section 165(g) worthless securities rules.

Section 165(g) provides for a deduction for losses from worthless securities that have become worthless. To qualify for the deduction under section 165(g), the cryptocurrency would have to be considered a security. Factors that may be considered in determining whether cryptocurrency is a security include the manner in which it was offered and sold, the existence of a central authority or promoter, and the reasonable expectation of profits from the investment.

The IRS guidance concludes that crypto is not a security, as defined in Section 165(g). The term only includes corporate stock, etc. It also goes on to conclude that, given the facts, the decline in value did not result in a “worthless” security. The investment still had some value. This is consistent with the court’s prior rulings on worthless partnership interests, for example.

Sec. 165 Casualty or Theft Loss Limits

Under the Tax Cuts and Jobs Act (TCJA) of 2017, the ability to deduct theft and casualty losses for personal property, including cryptocurrency, is limited. The deduction for theft and casualty losses is only available if the loss is incurred in a federally declared disaster area.

The IRS guidance does not address these rules given the fact pattern it addresses, but those who incur theft or casualty losses may need to consult these rules to see if their losses are allowable under the TCJA changes. These limits are only in place from 2018 through 2025, unless Congress acts to extend them.

Sec. 166 Crypto Tax Loss for Bad Debts

The IRS guidance does not address the Section 166 bad debt rules.

Section 166 provides for a deduction for business bad debts, which may include losses related to cryptocurrency. To qualify for the deduction under Section 166, the loss must be considered a business bad debt, meaning that the cryptocurrency must have been acquired or held for use in a trade or business.

Cryptocurrency held as an investment and becomes worthless isn’t a bad debt under Section 166. However, cryptocurrency held as inventory or in connection with a trade or business might be.

If this applied, to claim the deduction, one would just have to show that the debt is uncollectible and that reasonable steps have been taken to attempt to collect the debt. The deduction may be claimed in the tax year in which the debt becomes completely worthless, or in a subsequent tax year if it is determined to be partially worthless.

The Takeaway

The taxation of cryptocurrency is complex and involves various tax laws. Crypto tax losses can be used to offset gains and reduce tax, but it’s important to understand the specific rules for deducting losses. Cryptocurrency is treated as property for tax purposes, not as fiat currency, which triggers the complexity of this issue. There are limitations that may apply, such as limitations on deducting theft and casualty losses for personal property, short-term and long-term gains rules, and the limit on capital losses. This also creates opportunities, such as the wash sale rules not applying to crypto transactions.

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