When taxpayers sell digital assets at a loss, their tax loss is quite straightforward. Their loss equals the amount that their tax basis exceeds the amount they received for the sale.^[1] This is not the only way for a taxpayer to report a tax loss. A taxpayer can also deduct losses without actually selling the digital assets in some very limited circumstances. Internal Revenue Code (Code) §165(a) provides that a taxpayer can deduct—as an ordinary loss—worthless, abandoned, or stolen property (subject to a special rule for worthless securities). Whether a Code §165(a) loss is actually available, however, is anything but straightforward.

Given the large drop in the value of digital assets in 2022 and 2023, many taxpayers are desperately seeking ways to deduct their losses. Perhaps in response, the IRS Office of Chief Counsel issued Advice Memorandum CCA 202302011 (CCA).^[2] The CCA addresses those circumstances under which a taxpayer may deduct digital asset losses as “worthless” or as “abandoned” property^.[3]

CCA 202302011’s Guidance on Crypto Loss Deductions

The CCA set up a relatively simple fact pattern with a hypothetical taxpayer who purchased digital assets for $1 a unit in 2022. By the end of 2022, the units had declined in value to $0.01 per unit but they were still trading on at least one cryptocurrency exchange, and the taxpayer had not sold, exchanged, or otherwise disposed of any of its units. After setting up this simple fact pattern, the CCA then analyzed why the taxpayer could not deduct its losses under Code §165(a) because the crypto units were neither worthless nor abandoned.

Code §165(a) provides a deduction for losses “sustained” during the taxable year that are not compensated for by insurance or otherwise. Losses are sustained when they are “evidenced by closed and completed transactions, fixed by identifiable events.” A Code §165(a) loss generates an ordinary deduction, not a capital loss. This is the tax result without regard to whether the asset is a capital or ordinary asset. As a result, if crypto losses were available to the taxpayer, the losses would have been ordinary losses, deductible in the taxable year in which they were sustained.

An exception is provided for worthless securities. Losses on worthless securities are treated as though the loss resulted from a sale or exchange.^[4] Thus, if a security is a capital asset in the taxpayer’s hands, the taxpayer’s loss on worthlessness is capital. The CCA noted that the type of digital assets that were considered in the CCA were not securities (they were likely to have been stablecoins).

Determining When Crypto is ‘Worthless’ for Tax Deduction Purposes

The CCA states that although the taxpayer’s crypto had “substantially decreased in value,” the value was “greater than zero.” Moreover, the taxpayer still had dominion and control over the crypto, which continued to trade on at least one cryptocurrency exchange.

The CCA quoted a Tax Court case to the effect that property is worthless only if an economic loss in the value of property is “determined by the permanent closing of a transaction with respect to the property.”^[5] In other words, to receive a Code §165(a) loss, the taxpayer must show “an identifiable event that occurs during the tax year” that evidences the property is worthless. There must be a showing that “the asset in question is in fact essentially worthless.” Although “it is not necessary to relinquish title” to demonstrate worthlessness, a taxpayer must show that the asset has no current liquidity value and no prospect of acquiring “value in the future.”

The CCA does not offer any guidance as to how a taxpayer can demonstrate that there is no possibility of the crypto acquiring value in the future. As a practical matter, it is hard to imagine how a taxpayer can make such a showing, unless the digital assets were recorded on a blockchain that is no longer active.

Putting aside the future value issue for a moment, perhaps one method of showing that a digital asset has no liquidating value might be to document the taxpayer’s unsuccessful efforts to sell the cryptocurrency and that there were no buyers at any price. Perhaps it might be possible to make such a showing if a qualified appraiser issues an opinion that the cryptocurrency is worthless.^[6] There are serious questions as to whether a taxpayer could successfully show worthlessness.

Ascertaining When Crypto is ‘Abandoned’ Property

Abandonment is demonstrated by an evaluation of all of the surrounding fact and circumstances. This evaluation must make two things clear. First, the taxpayer must show a subjective intent to abandon the property. And second, the taxpayer must take affirmative actions to actually abandon it.^[7] As the CCA notes, intention alone “is not sufficient to accomplish abandonment.” With intangible assets, such as crypto units,^[8] there must be an explicit manifestation of abandonment.

Based on the facts presented in the CCA, the hypothetical taxpayer did not take any affirmative steps to abandon the cryptocurrency. The taxpayer continued to have dominion and control over it; retained the ability to sell, exchange, or otherwise dispose of it; and took no steps to demonstrate it was abandoned. Therefore, the CCA makes it clear that this taxpayer did not sustain a Code § 165(a) abandonment loss.

Unfortunately, the CCA is silent as to the types of actions a taxpayer might take to demonstrate an affirmative act of abandonment. Cryptocurrency is not like an old car that a taxpayer can just have towed away. Indeed, the only affirmative act of abandonment that I can think of would be for a taxpayer to send the crypto to a null address. A null address, sometimes called a “burn address” or “eater address,” is a digital wallet specifically set up to receive crypto that is to be permanently removed from circulation. While the current balance of such an account is publicly visible on the blockchain, its contents are unavailable to anyone.^[9]

Tough Questions Remain When It Comes to Crypto Losses and Tax Deductions

Taxpayers are now on notice that even if they experience a dramatic decline in the value of their cryptocurrency, this is not sufficient to trigger a Code §165(a) loss. This conclusion is an obvious one, and it should not be a surprise to anyone.

The CCA, however, skirted around some of the toughest questions with respect to crypto losses. For example:

• Can a taxpayer take a Code §165(a) loss if its digital assets are frozen on a bankrupt exchange?

• What if the crypto is listed for trading on an exchange but there are no buyers?

• Why did the IRS go through such a detailed analysis in the CCA when Code §67(b)(3) prohibits individual taxpayers from deducting such losses until taxable years beginning in 2026?

• How could a taxpayer send crypto units to a null address if the taxpayer cannot get access to the units because they are held by a bankrupt exchange, such as FTX?

• How can a taxpayer demonstrate that its digital assets have no future value? Are there other ways that a taxpayer can show worthlessness?

• If a null account is not provided for with respect to a particular blockchain, how can a taxpayer demonstrate “abandonment?”

The bottom line is that the CCA tells us that the IRS is paying close attention to how taxpayers report their crypto losses on their tax returns. A careful review of CCA 202302011 reveals that the IRS does not provide taxpayers with useful advice as to how they can appropriately qualify for tax losses on worthless or abandoned crypto.

[1] Subject to limitations on the amount and timing of capital loss deductions.

[2] Jan. 10, 2023.

[3] In a future article, I will discuss the deductibility of cryptocurrency theft losses also covered in Code §165.

[4] Code §165(g).

[5] See Massey-Ferguson, Inc. v. Comm’r, 59 T.C. 220, 225 (1972) (citing Boston Elevated Railway Co. v. Comm’r, 16 T.C. 1084, 1108 (1951), aff’d, 196 F.2d 923 (1st Cir.1952)).

[6] A qualified appraiser is an individual with verifiable education and experience in valuing the type of property for which the appraisal is performed. Treas. Reg. §1.170A-17.

[7] Beus v. Comm’r, 261 F.2d 176, 189 (9th Cir. 1958), aff’g 28 T.C. 1133 (1957).

[8] Citron v. Comm’r, 97 T.C. 200, 209-10, 213 (1991) (finding that taxpayer abandoned a partnership interest when the limited partners voted to dissolve the partnership, directed that a final partnership return be filed, and treated partnership property as no longer belonging to the limited partners).

[9] What is the Null Address in Crypto? Nov. 19, 2021, https://educationecosystem.com/blog/what-is-the-null-address-in-crypto/.