In the cryptocurrency space, it is quite common to own coins that drop to zero value. The savvy investor can use the IRS abandonment loss provision (more favorable than capital losses capped at $3,000 a year) to get a tax write-off for these coins without selling them.
How capital losses work
A capital loss occurs when you have a “sale or exchange” of an asset at a loss (Code Sec. 1222(2) and Code Sec. 1222(4)). For example, say you have 1 bitcoin (BTC) purchased at $50,000 that you go on to sell at $40,000. You now have a $10,000 capital loss ($40,000 - $50,000). The $10,000 capital loss is realized because you disposed of the bitcoin in exchange for cash at a price lower than what you paid for the bitcoin to begin with. This meets the “sale or exchange” criteria under the capital loss definition.
If the coin has no active market (no liquidity), you cannot create a capital loss because there is no counterparty to establish a “sale or exchange.” The mere fact that a coin’s liquidity, price, or market have gone to zero is insufficient to claim a capital loss. However, in such cases, you may be able to take a deduction for the coins under the abandonment loss provision of the IRS tax code.
Each loss may qualify as an “abandonment loss” based on the facts and circumstances of the specific case. Highlighted sections of the definition below are quite important because they help you determine if you really have an abandonment loss.
Under § 1.165-2 of the tax code, an abandonment loss is a “a loss incurred in a business or in a transaction entered into for profit and arising from the sudden termination of the usefulness in such business or transaction of any non-depreciable property, in a case where such business or transaction is discontinued or where such property is permanently discarded from use therein, shall be allowed as a deduction under section 165(a) for the taxable year in which the loss is actually sustained.”
In simple terms, to confirm whether you qualify for an abandonment loss, ask yourself these questions with regard to the cryptocurrency you are holding that has gone to zero:
- Did you invest with the intention of making a profit?
- Did the cryptocurrency suddenly stop being valuable?
- Is it a non depreciable property? (yes: all cryptocurrencies are non-depreciable property)
- Did you permanently discard the worthless coins? (e.g. for example sending them to a null address?)
If you answer “yes” for all of the above questions, you could treat your loss as an abandonment loss. Make sure you document the answers for these questions along with proof of your ownership of coins prior to abandonment, an intent to abandon the coins and the actions you took to abandon the property (three-prong test set by the tax courts). These records will come in handy in case the IRS questions your deduction.
Abandonment losses are reported on Form 4797, line 10. These losses are considered ordinary losses and not subject to capital loss limitation rules. You can report the loss in the year you incurred the loss, in other words, in the year you ceased ownership of the coins.
Cryptocurrency abandonment loss example
Let’s use an example to apply these rules. Say Sam purchased 1,000 ABC coins for $1,000 in an ICO conducted in 2017. He invested this $1,000 with the intention of cashing out at a much higher price when the mainnet launches in 2019. In 2021, he realizes that the project has stalled, and there is no chance of a mainnet launch. Online research and other third parties confirm that the project is abandoned without any prior notice. Further, there’s no active market to sell ABC coins which are now worthless. Sam sends 1,000 ABC coins to a null address to cease ownership of ABC.
Answering following questions can help us figure out if Sam has an abandonment loss:
- Did Sam invest in a cryptocurrency with the intention of making a profit?
Yes, he wanted to cash out and make profits once the mainnet was launched.
- Did Sam experience a sudden termination of the usefulness in such a business or transaction?
Yes, during 2021 Sam realized that there is no active market for ABC because the project failed. Online research and other third-parties also confirmed this.
- Is cryptocurrency a non depreciable property?
Yes, cryptocurrencies are non depreciable property.
- Did Sam permanently discard the coins from use by sending them to a null address?
In 2020, Sam sent the coins to a null address so he could prove that he permanently discarded the coins.
Conclusion: Sam can report a $1,000 as an abandonment loss in his 2020 taxes.
Since taking an abandonment loss is based on facts and circumstances of each case, there is no shortage of Tax Court cases dealing with the issues surrounding the deductibility of abandonment losses. Therefore, having detailed records and documentation is crucial before claiming losses on your tax return.
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Disclaimer: This post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.