Paul L. Caron

Friday, June 23, 2023

Weekly SSRN Tax Article Review And Roundup: Kim Reviews Crypto Losses By Nguyen & Maine

This week, Young Ran (Christine) Kim (Cardozo; Google Scholar) reviews Xuan-Thao Nguyen (Washington) and Jeffrey A. Maine (Maine), Crypto Losses 2024 U. Ill. L. Rev. __ .

Kim (2023)Recently the crypto industry has been hit hard by various market forces and scams, leaving investors with trillion-dollar losses. In January 2023, in response to confusion surrounding abandoned and worthless cryptocurrency, the IRS weighed in on the deductibility of crypto losses (see ILM 202302011). The Chief Counsel Advice Memorandum stated the obvious—that taxpayers cannot claim an abandonment loss without an affirmative act (like sale or exchange) and cannot take a worthless deduction for the temporary decline in value. Furthermore, even if the loss was realized, the loss deduction would be disallowed because section 67(g) suspends miscellaneous itemized deductions for taxable years 2018 through 2025.

This guidance left many questions unanswered. The appropriate tax treatment of crypto losses has yet to be fully examined, as there is scant guidance and a dearth of academic literature on the subject. Xuan-Thao Nguyen (Washington) and Jeffrey A. Maine (Maine)'s recent article, Crypto Losses, 2024 U. Ill. L. Rev. (forthcoming), attempts to fill this gap by applying general tax principles to crypto losses and making several recommendations to improve the clarity and consistency of tax treatment. Nguyen, an expert in business and IP law, and Maine an expert in tax law, are co-authors of a well-known casebook on Intellectual Property Taxation.

First, Nguyen and Maine explore the nature and magnitude of crypto losses, because the nature of a loss affects the tax results. For example, many crypto owners have "lost" their crypto by misplacing their private keys, sending crypto to a wrong wallet, or losing their cold storage device. Many have seen their cryptocurrencies "stolen" through various hacks and scams. Many still have possession of their crypto but have since seen their values drop significantly because of the bad acts of blockchain managers.

Nguyen and Maine further examine the general deduction rules governing losses and the difficulties associated with applying them to crypto losses. To claim a loss deduction under current law, (1) the losses should be realized; and (2) a specific statutory authorization for deduction is required. As to the second requirement, the statutory framework for the deductibility of "realized" crypto losses is straightforward. Losses in money-making endeavors (i.e., business losses and investment losses) are generally allowed. Personal losses, in contrast, generally are not. But there are exceptions and limitations: for example, personal casualty or theft losses are deductible. In contrast to the statutory authorization, the requirement of whether losses are "realized" is a more difficult hurdle for claiming crypto losses.

Realization usually does not occur until there has been an identifiable event, such as a “sale or other disposition” of the property. Hence, decreases in the value of cryptocurrencies are not considered for tax purposes as they accrue, but only when they are realized. On the other hand, trading one crypto for another crypto or non-crypto goods is considered a realization event. A casualty is also considered a realization event. However, courts generally require physical damage to property—a hurdle for cryptocurrency victims. Furthermore, temporary declines in market value due to a casualty event do not qualify as casualty losses.

A theft is also considered a realization event, but the ability of cryptocurrency owners to claim theft losses is far from certain. For example, if cryptocurrency is stolen by hackers, a theft loss is likely sustained. A more difficult question, however, is whether cryptocurrency owners can claim theft losses relating to the decline in the value of crypto caused by bad acts of crypto managers (fraudulent representations, criminal violations of securities laws, etc.). In the context of open market stock transactions, shareholders have not had much success. (See Elec. Picture Solutions, Inc. v. Commissioner, T.C. Memo 2008-212.) Nonetheless, the IRS has the discretion to bend the rules, somewhat paving a path toward theft loss deduction in such cases. In the aftermath of the 2008 financial crisis when thousands of investors lost billions of dollars in fraudulent Ponzi schemes (such as those operated by Bernie Madoff), the IRS issued an ad-hoc guidance in 2009 to offer a safe harbor permitting eligible victims to deduct losses. (See Rev. Rul. 2009-9, 2009-14 I.R.B. 735; Rev. Proc. 2009-20, 2009-14 I.R.B. 749.) Recent cryptocurrency schemes, such as those used by Sam Bankman-Fried of FTX, are now raising questions about the 2009 guidance’s relevance.

Lost possession and abandonment of crypto are likely realization events because abandonment of property is a realization event for tax purposes. The more difficult question is whether an abandonment loss could be sustained on the significant decline in the value of crypto. In stock cases, affirmative acts of abandonment (such as surrendering shares back to the company) are needed. To abandon crypto then, it would seem necessary to take similar steps, such as sending the crypto to a null address (also known as a burn address) where the crypto will be taken out of circulation. But this step could not be taken if a crypto owner does not have access to the cryptocurrency to dispose of them. Often when cryptocurrency is worthless, the platform is also in trouble and the gate might be up (the first step towards bankruptcy). If the platform is already in bankruptcy administration, acts of abandonment might be difficult. In this case, can a crypto owner claim losses based on worthlessness instead of abandonment? Nguyen and Maine offer a nuanced and sophisticated explanation and imply that such claim may be difficult based on the 2023 IRS guidance. I recommend reading Part II.A.4. of the Article for more discussion on this topic. 

Finally, the Article proposes a possible basket approach for crypto losses—that is, crypto losses should be deductible only against crypto gains and not against labor or other income. If the tax system permits a tax deduction for crypto losses, the government is essentially sharing in the risk created by the investors' activities. This risk-sharing can encourage investment in cryptocurrency and discourage other investment activities of economic significance. Hence, Nguyen and Maine take a modest position by endorsing the narrow deductibility of crypto losses, supported by many loss limitation rules that already exist in our tax system (like wagering losses and hobby losses).

This article is an excellent piece for those who are interested in the doctrinal analysis of crypto losses under current law. It also raises various policy questions and considers a wide spectrum of answers—from complete disallowance of crypto loss deductions to expansion of the loss deductions. The authors' thoughtful discussion would benefit policymakers who mull over the distressed crypto issue and aim to find a balanced approach between minimizing revenue losses and sympathizing with the crypto victims.

Here’s the rest of this week’s SSRN Tax Roundup:

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