Updated IRS Guidance on Donated and Worthless Crypto
If you are thinking about making a charitable contribution, or trying to determine the impact of worthless digital assets, the IRS released a new memo to clarify proper tax treatment. While this is not considered substantial authority, it does give us a look into how the IRS believes current regulations should be applied.
Charitable Contributions
You were always able to receive a deduction for a contribution of a digital asset to a qualified 501(c)(3) organization. However, the IRS now clarified that all donations of digital assets over $5,000 must be professionally appraised. This applies to all digital assets, even those with readily identifiable market values (such as Bitcoin and Ethereum).
Most charitable organizations already require an appraisal and can provide the service for you.
Worthless Crypto and NFTs
Digital assets are similar to securities in that you can recognize a capital loss if sold for less than the adjusted basis of the asset. However, if you own a security, you are able to recognize a capital loss, without sale or disposal, when your asset is deemed worthless:
“Section 165(g) provides that if any security which is a capital asset becomes worthless during the taxable year, the loss shall be treated as a loss from the sale or exchange of a capital asset. Section 165(g)(2) defines a security as a share of stock in a corporation; a right to subscribe for, or to receive, a share of stock in a corporation; or a bond, debenture, note, or certificate, or other evidence of indebtedness.”
Digital assets are not included in Section 165(g) and are subject to a special set of rules. In order to be deemed worthless, they must:
Have no current or foreseeable future value
Have zero liquidity on any exchange (there is no possibility to sell or swap the asset)
Many crypto investors, including those who owned Luna, may find themselves with what they believe is a worthless digital asset. It is difficult to prove that digital assets have zero liquidity, as even the smallest of altcoins have users and developers that provide liquidity. However, if you can prove there is no liquidity, then you can deem your digital asset worthless (without sale or disposal).
You’ve determined your digital asset is worthless or abandoned. Is it deductible?
If you are an individual investor, this loss will not be deductible. The IRS classifies digital assets as property. Any loss from abandoned or worthless property results in an ordinary loss. However, these ordinary losses were suspended in 2017 and are not deductible until, at least, 2026 as a miscellaneous itemized deduction (per the Tax Cuts and Jobs Act of 2017). These losses also do not carry over. If you try to recognize a loss on a worthless digital asset in 2022, it will be disallowed and lost forever. Even after proving your digital asset is worthless, your best course of action is to sell your digital asset for a nominal sum and recognize a capital loss.
A different set of guidelines applies if you acquired digital assets related to your trade or business (this includes day traders, merchants that accept crypto and professional gamblers that keep online account balances in crypto). Any worthless digital assets that are business-related can be realized as an ordinary loss. This loss can be recognized in the year the digital asset is deemed worthless. Be aware, if you do not dispose of the digital asset, you may be subject to tax if it regains value in the future.
Although these are the general guidelines, there are certain circumstances where special rules may apply. Make sure to discuss your specific situation with your tax professional to ensure the correct interpretation and application of guidance.