The digital asset or crypto ecosystem has experienced a series of ups and downs. Some crypto investors have been unsuccessful following the internet financial advice of professional boxers who had chosen a career of getting punched in the face. US taxpayers who have lost money on their digital asset investments, or had them stolen, may be able to hard fork lemonade classic tokens out of lemons by deducting tax losses.
Capital Losses From Sales or Exchanges
A taxpayer’s most typical losses are capital losses from the sale or taxable exchange of a crypto asset. Capital losses can offset capital gains, both long-term and short-term, and up to $3,000 per year of ordinary income.
Example: Bette purchased some titan for $200,000. She converts the titan into iron later in the year, at a time when her titan was worth $900,000, and recognizes $700,000 of taxable short-term capital gain. In year two, she sells the iron for $100,000 and recognizes $600,000 of capital loss in year two.
The year-two capital loss can only be carried forward, indefinitely. They cannot be carried back to year one to offset the capital gains and any ordinary income in year one—such as the liquidity pool yield rewards with annual percentage yields of somewhere between 20% and 4,000,000,000%.
The technique of paying a large tax at ordinary income rates, and then generating significantly less useful capital losses after selling in a falling market, is sometimes considered a huge tax break that, though it may sound suspect, is still legal.
Abandonment or Worthlessness Loss
In contrast with capital losses from sales or exchanges, abandoned or worthless crypto results in ordinary losses. But the catch is that the ordinary losses are miscellaneous itemized deductions that are not deductible until 2025. Accordingly, it is better to get out early by selling the assets (see above) or to have them stolen (see below).
The Tax Cuts and Jobs Act of 2017 provides that an individual’s miscellaneous itemized deductions are not deductible in 2018 through 2025. The tax code defines “miscellaneous itemized deductions” as generally all deductions other than: deductions that reduce adjusted gross income, such as trade or business deductions or losses from the sale or exchange of property; deductions for interest and taxes; casualty or theft losses incurred in any transaction entered into for profit; charitable contributions; and various other minor categories.
Abandonment or worthlessness losses from an investment asset are not any of the above categories and are therefore nondeductible miscellaneous itemized deductions.
Example: Helena purchased $5,000 of luna, a few days before it plunged to $0.001 in value. She experiences difficulties selling the luna because it is hard to be paid a fraction of a cent. She ends up too late with a $5,000 abandonment or worthlessness loss that is not deductible.
Abandonment or worthlessness losses are more useful as above-the-line deductions that reduce adjusted gross income if they arise from a trade or business, such as an initial coin offering trading business or a retailer that accepts shiba inu in payment.
Theft Losses
In 2008, many individuals lost their invested funds to Bernie Madoff, who generated a 10.5% annual return that turned out to be an unsustainable Ponzi scheme. The Madoff losses were itemized deductions that can offset an unlimited amount of ordinary income. The Madoff losses were not “miscellaneous itemized deductions” because they fit within the exception in the third category above, as theft losses incurred in any transaction entered into for profit.
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