Although the IRS provided guidance recently in when it issued Revenue 2019-24, as previously discussed here, there are still many questions that remain unanswered by IRS guidance. Among the questions unanswered include how one should report cryptocurrency that is lost or stolen. This article discusses available reporting options.
While cryptocurrency is well known for its security, most first-time users may use a cryptocurrency exchange that has a security breach, for example in 2019 the Taiwan based exchange Binance suffered a $40 million worth of Bitcoin theft. In that instance the theft was covered by insurance, but in other cases the theft or loss may not be covered by insurance or ever be recovered by the individual who suffered the loss. With the popularity of cryptocurrency exchanges there have been some new exchanges introduced that are actually just receiving money without the intention of holding it for the account holders, and then the exchange will shut down, similar to a ponzi scheme this theft is called an exit scam. A more secure method of holding electronic currency is by holding your own keys and storing your cryptocurrency in cold storage, but if you lose your keys the cryptocurrency will never be recovered.
There are three potential reporting options by individuals: as a casualty or theft loss, as an investment loss, or as an abandonment loss. Each are addressed below.
Casualty or Theft Loss
In the past, casualty or theft losses were generally the preferred reporting classification because they could, in certain circumstances, generate an ordinary loss which could be used to offset ordinary income. Casualty or theft losses are not the currently preferred methods of reporting a transaction, however, because under the 2017 tax act, for tax years 2018 through 2025, an individual's personal casualty and theft losses generally are deductible only to the extent that they are attributable to a federally declared disaster. A federally declared disaster is one declared as such by the President under section 401 of the Robert T. Stafford Disaster Relief and Emergency Assistance Act. I.R.C. § 165(h)(5)(A). Personal casualty losses that are not attributable to a federally declared disaster can be deducted, but only to the extent that the individual has personal casualty gains. Practically, casualty or theft losses are no longer deductible for most individuals.
After 2025, however, the old rules will resume, and an individual taxpayer must be prepared to establish the following to claim casualty loss:
(1) the nature of the casualty and when it occurred;
(2) that the loss was the direct result of the casualty;
(3) that the taxpayer was the owner of the property;
(4) the cost or other adjusted basis of the property;
(5) the depreciation allowed or allowable, if any;
(6) the values before and after the casualty;
(7) the amount of insurance or other compensation received or recoverable;
(8) that the property on which the loss is claimed was the property that sustained the injury;
(9) that the year in which the loss is claimed is the year in which the loss is deductible; and
(10) that there is no reasonable prospect of recovery at the end of the year for which the loss is claimed.
I.R.C. § 165(c)(3); Treas. Reg. § 1.165-1(d).
Similarly, an individual taxpayer must be prepared to establish the following to claim a theft loss:
(1) the loss was caused by theft;
(2) the amount of the loss; and
(3) the year in which the loss is claimed is the year in which the theft loss was incurred or discovered.
I.R.C. § 165(c)(3); Treas. Reg. § 1.165-8.
Since neither casualty or theft losses are deductible until after 2025, except to the extent that they are attributable to a federally declared disaster or used to offset personal casualty gains, this is unlikely to be beneficial for individuals that lose or have their cryptocurrency stolen.
Individuals may deduct losses that are incurred in a trade or business (“business losses”), and losses incurred in any transaction entered into for profit, though not connected with a trade or business (“investment losses”). I.R.C. § 165(c)(1), (2). Assuming that a taxpayer is not acquiring cryptocurrency as part of a trade or business, then investment losses may be available if the taxpayer can show that the transaction was entered into for profit.
Cryptocurrency is treated as “property” under IRS Notice 2014-21. When an individual holds cryptocurrency outside of his or her trade or business, it generally will be classified as a capital asset. See Notice 2014-21, Q&A 7; I.R.C. § 1221. Because cryptocurrency losses incurred in a transaction entered into for profit are considered capital assets, there must be a sale or exchange of the cryptocurrency to generate an investment loss that can be utilized as a deduction in determining a taxpayer's adjusted gross income. I.R.C. §§ 165(f); 1211(b); 62(a)(3); Treas. Reg. 1.62-1T(c)(4).
Will cryptocurrency that is stolen or lost satisfy the “sale or exchange” requirement necessary to claim an investment loss? The Tax Code does not define the phrase “sale or exchange,” or its separate components – sales, exchanges. Although I.R.C. § 1001(a) uses “sales or other disposition,” the phrase “other disposition” has been interpreted to be broader than “exchange.” Helvering v. William Flaccus Oak Leather Co., 313 U.S. 247 (1941). Accordingly, it may be that cryptocurrency that is lost or stolen will satisfy “other disposition” as used in section 1001, but still not be deductible because it does not rise to the level of an exchange.
The phrase “sale” has been given its ordinary meaning and is generally defined as a transfer of property for money or its equivalent or a promise to pay money or its equivalent. Commissioner v. Brown, 380 U.S. 563, 570-71 (1965); Nahey v. Commissioner, 111 T.C. 256 (1998), aff'd on other grounds, 196 F.3d 866 (7th Cir. 1999), cert. denied, 121 S. Ct. 45 (2000). A key factor used in determining whether a sale has occurred is whether the benefits and burdens of ownership have been transferred. Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221 (1981). Courts have also considered the following factors:
(1) whether legal title has passed;
(2) how the parties treat the transaction;
(3) whether the purchaser has acquired an equity interest in the property;
(4) whether the acquisition creates a present obligation on the seller to transfer legal title for an agreed-upon consideration;
(5) whether the right to possession has vested in the purchaser;
(6) which party pays the property taxes;
(7) whether the purchaser bears the risk of loss (including depreciation in the value of the property) or damage to the property; and
(8) whether the purchaser receives the profits (including appreciation in the value of the property) from the operation and sale of the property.
Although neither the IRS, nor a court has addressed whether lost or stolen cryptocurrency will constitute a sale, it will likely be difficult to obtain such treatment. The transferor unwillingly transferred the cryptocurrency in a theft, and has not received money or its equivalent or a promise to pay money or its equivalent, and where cryptocurrency has been lost, there may not be a transferee that has received the lost cryptocurrency. But neither foreclose the opportunity to argue that a sale has occurred since many of the other factors the courts consider, noted above, weigh in favor of sale treatment.
The phrase “exchange” has been defined as a transfer of property for other property. Helvering v. William Flaccus Oak Leather Co., 313 U.S. 247 (1941) (“exchange . . . implies reciprocal transfer of capital assets”). The Supreme Court's definition of this phrase likely precludes a taxpayer from arguing that lost or stolen cryptocurrency is an exchange since he or she will not have received anything in exchange for the cryptocurrency.
Unless a taxpayer can establish that cryptocurrency lost or stolen constitutes a sale, he or she will be unable to claim an investment or capital loss.
Abandonment loss is likely to be a boon to the taxpayer whose cryptocurrency is lost or stolen.
A taxpayer who abandons property held for use in a trade or business or in a transaction undertaken for profit is entitled to a loss based on the property's adjusted tax basis. An abandonment does not require the relinquishment of possession or legal title; however, the taxpayer must establish his or her intent that the abandoned property will not be used again by him or her and will not be retrieved by him for sale for other disposition.
An individual taxpayer must be prepared to establish the following to claim an abandonment loss:
(1) the loss was incurred in an activity entered into for profit;
(2) the taxpayer has taken actions and evidence intent to constitute an abandonment;
(3) the abandonment did not involve receipt of consideration; and
(4) the abandoned asset is not that described in I.R.C. § 1234A.
Each element are discussed below.
Entered Into For Profit
A taxpayer does not actually have to commence a transaction for profit to claim the abandonment loss. It is sufficient if the abandoned property was acquired for use in such an activity. See Price v. Commissioner, T.C. Memo 1971-323 (1971); Duryea v. Commissioner, 6 T.C.M. 926 (1947). If a taxpayer merely uses cryptocurrency for everyday purchases and does not hold it for investment, then the taxpayer may not be able to satisfy the “entered into for profit” element.
Actions and Intent to Abandon
Treasury Regulation § 1.165-2(a) requires that there be an intention to immediately and permanently cease using property, and the intention be evidenced by the actions of the taxpayer. Treas. Reg. § 1.165-2(a). It does not matter whether the taxpayer continues to possess the property, or whether the taxpayer continues to maintain legal title to the property. Id. The mere intention to abandon is not, nor is non-use of property alone, sufficient to accomplish abandonment. Beus v. Commissioner, 261 F.2d 176, 180 (9th Cir. 1958).
Neither the IRS nor the courts have addressed abandonment in a cryptocurrency scenario, however, non-cryptocurrency abandonment cases establish that failed attempts to sell an asset, notification to a broker to discontinue sale, or simply deciding that litigation to recover possession of an asset would be futile, Allen v. Commissioner, T.C. Memo 1994-165, have been determined to be acts of abandonment.
If an owner misplaces a cryptocurrency key or password or it is otherwise compromised, the taxpayer may be able to establish abandonment by making an effort to locate or retrieve such key or password and then determining that future efforts would be futile.
No Receipt of Consideration
Abandonment losses do not apply to losses sustained on the sale or exchange of property. Treas. Reg. 1.165-2. If a taxpayer receives any consideration from a transferee, then the taxpayer will be treated as having sold or exchanged the property no matter how de minimis the consideration received. See, e.g., CCA 201025047. This is unlikely to be a hurdle where a taxpayer's cryptocurrency is lost or stolen since presumably no transferee is available to compensate the taxpayer.
No Application of I.R.C. § 1234A
I.R.C. § 1234A deems certain transactions as a sale transaction, which precludes a taxpayer from claiming an abandonment loss. Treas. Reg. 1.165-2. Although section 1234A appears to subject losses attributable to an abandonment of a capital asset to capital loss limitations, the IRS has rejected this view. The legislative history of the act suggests that its intent was to cause certain transactions which are the economic equivalent or a sale or exchange to be taxed in the same manner as a sale or exchange and that Congress did not consider abandonment to be an equivalent. IRS Publication 544 supports this view because it provides that “[a] loss from an abandonment of business or investment property that is not treated as a sale or exchange generally is an ordinary loss.”
Will an abandonment loss be subject to capital loss limitations? No. The limitations on the deductibility of “capital losses” apply only to a loss from the sale or exchange of a capital asset. I.R.C. § 1211(a), (b). Accordingly, a loss on the abandonment of a capital asset will not be subject to the capital loss limitations (i.e., it will be treated as an ordinary loss) unless the abandonment is a sale or exchange for one of the following reasons: (1) the taxpayer received, or is deemed to have received, consideration in connection with the abandonment, or (2) an applicable statute provides that the transaction is to be treated as a sale or exchange, I.R.C. § 1234A.
How you treat your lost or stolen cryptocurrency for tax purposes requires complex, fact-intensive analysis. Generally, there are three potential reporting options by individuals, and because of the 2017 tax act, classifying these losses as an abandonment loss is likely to result in the most favorable taxpayer treatment. However, you should seek the guidance of a tax attorney for any material transactions because IRS enforcement efforts are underway (the IRS recently sent Letter 6173, Letter 6174, and Letter 6174-A to 10,000 taxpayers with known cryptocurrency transactions) and reliance on a tax attorney will help you minimize civil and criminal exposure.
If you find yourself subject to an IRS audit and you have cryptocurrency transactions in the year under audit, you should not proceed without the assistance of a tax controversy attorney.