The Terra collapse is creating new crypto tax questions for the IRS

Last month, the collapse of the TerraUSD stablecoin and a related Terra-based asset called luna led many people to sustain considerable losses. 

While losses are never the desired outcome in investing, they can open the door to offset other tax burdens. Now some tax experts are debating whether that is case for US investors who lost money due to the Terra collapse.

The specific question is whether a taxpayer who lost money in the collapse can claim something called an “abandonment loss,” which lets investors reduce their tax bill by offsetting their capital gains with their capital losses.

Shehan Chandrasekera of crypto tax startup CoinTracker has put forth the idea that luna could qualify as obsolete property, which could make it possible for holders to claim abandonment loss. But even if luna qualifies as a worthless asset, it’s unclear how to effectively “abandon” it — and, even if it were successfully abandoned, how the Internal Revenue Service (IRS) would view it.

The answer may come down to whether it’s possible — in the eyes of the IRS — to truly dispose of a crypto token.

“Abandoning” luna

Tax professionals on Twitter are floating the possibility of abandoning luna given the coin’s steep drop to near-zero. 

Usually, losing money on investments results in a capital loss. A US taxpayer can use their capital losses to offset their capital gains and reduce their tax bill. If their losses exceed their gains, they can also write off up to $3,000 against their ordinary income and carry over any remaining losses to offset capital gains in future years.

But US taxpayers also have the option to claim something called an “abandonment loss” if they find themselves in possession of obsolete property, or property that has suddenly become worthless. That allows them to realize their loss against their income, which can reduce their tax burden even more. 

According to the tax code, an asset with potential for abandonment includes “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.”

Essentially, a taxpayer can abandon certain kinds of assets if they had to invest in them with the intention of turning a profit only to experience a sudden, stark decrease in value. A real-world example of a non-depreciable asset includes land, but securities could also be considered non-depreciable property.

Under this definition, TerraUSD probably couldn’t qualify for abandonment, since it touted itself as an algorithmic stablecoin. It’d be hard to make the case that investors were owning it with the intention of making a profit. But luna, which fluctuated in value, might fulfill these parameters. 

Here’s the issue, though: in order to argue that the asset qualifies for abandonment, taxpayers would still have to “abandon” the tokens. And the IRS hasn’t explained how to do that. 

Usually, abandonment cases relate to physical property or real-world projects that failed to move forward — for instance, a business that produces a product that quickly becomes obsolete, or a studio that purchases rights to a movie and physical objects to produce a film that never gets made. In these cases, the taxpayer can’t sell off these purchases because they’ve become obsolete. To recognize abandonment, they have to dispose of the assets and forego the ability to use them, sell them or retrieve them in the future. 

The recent attempts to revive the Terra network could throw a wrench in the argument that those assets are obsolete.

Meanwhile, some tax professionals have suggested that perhaps the taxpayer could send the tokens to a null address, or an address that is specifically generated to burn tokens. In theory, that would render them essentially unusable since no one has the means to access the wallet. 

Though it’s easier to dispose of a physical item, the tax code does address how to abandon a traditional security: “To abandon a security, a taxpayer must permanently surrender and relinquish all rights in the security and receive no consideration in exchange for the security.”

But in this case, the taxpayer would likely claim “worthless securities” which is a different treatment from a traditional abandonment loss. It still usually leads to recognizing the loss as a capital loss rather than an ordinary loss.

A long year ahead

It’s only midway through the tax year, so there’s time yet to consider options or for the IRS to clarify whether it’s possible to claim abandonment loss if a crypto-asset collapses the way luna did. But it’s more likely that the tax agency will cross that bridge only if taxpayers try to cross it — and then it happens to audit one of those people. 

Miles Fuller, head of government solutions at TaxBit and former senior counsel for the IRS said the IRS doesn’t necessarily seek people out to audit them for issues like this. 

“It's more likely that they're auditing somebody who happens to have this issue," he said. "Okay, now we have someone with this actual issue, we need to actually decide what the answer is."

And in that case, Fuller said, it likely wouldn’t result in a penalty for the taxpayer. The IRS would probably just request that they adjust the return. But it may also take such an opportunity to clarify the situation for the whole community.