Cryptocurrency: when can you claim tax losses in a falling market?

Over the past year, the world has seen the prices of many cryptocurrencies drop sharply. This has led investors, traders and companies to crystallize losses or have unrealized losses on their books.

From a tax point of view, the question is whether these losses are deductible.

What is crypto for tax purposes?

Crypto has been defined as:

a digital currency in which transactions are verified and records maintained by a decentralized system using cryptography, rather than a centralized authority.

For tax purposes, crypto is not a currency; it is however a CGT asset.

What is the correct tax treatment?

In the tax world, there are three possible ways to characterize crypto. Crypto can be:

  1. an investment asset – meaning it is generally held as capital and losses can potentially only be applied against future capital gains
  2. an asset purchased under a for-profit program – meaning any losses will only be recognized once the crypto is disposed of
  3. an asset purchased as a company’s trading inventory – meaning that trading inventory provisions work to determine when loss deductions can be applied.

Case study

Bessie the Sheepdog operates a business through her company Bessie Pty Ltd. It creates and markets non-fungible tokens (NFTs). Bessie uses the crypto, DoggyCoin, to buy NFTs and receives DoggyCoin when she sells her NFTs.

Bessie’s company usually has large reserves of DoggyCoin which it uses to acquire NFTs and pay for business-related expenses. In the 2022 revenue year, DoggyCoin experienced a significant drop in price.

Bessie needs to determine how these unrealized losses are treated for income tax purposes. If the DoggyCoin is a capital asset or purchased as part of a for-profit program, any losses will only be available once the DoggyCoin has been sold and the losses are realized.

In this case however, provided that the company operates an NFT trading business, its DoggyCoin is likely to trade shares. This is also the ATO view. The question is probably whether Bessie Pty Ltd meets the operating threshold of a business.

What does this mean for Bessie Pty Ltd?

If DoggyCoin trades in stocks, then Bessie’s company:

  1. recognizes the cost of acquiring DoggyCoin as a deduction
  2. counts the sale of any DoggyCoin as taxable income
  3. shall, at the end of each income year, determine the difference between the value of the trading stock at the beginning of the year and at the end of the year, and:.
  • if the value is higher at the end of the year, the difference will be the taxable income
  • if the value is lower at the end of the year, the difference will be a deduction.

Above all, Bessie can choose to value DoggyCoin at the end of the year at her sale market value. This may mean that Bessie’s company can access the company’s unrealized losses on the decline in value of her DoggyCoin and claim that as a deduction.

Conclusion

Tax loss rules can be complicated, especially in the context of stock and cryptocurrency trading.