The Internal Revenue Service (IRS) defines digital assets as digital representations that are recorded on a cryptographically secured distributed ledger.¹ Digital assets include cryptocurrency, which is a type of virtual currency that leverages cryptography to secure transactions that are recorded on a blockchain. Digital assets also include nonfungible tokens (NFTs), which are unique digital identifiers used to certify authenticity and ownership of the associated rights or assets.

Due to the popularity that cryptocurrencies and NFTs gained in the last three years, the IRS started scrutinizing all cryptocurrency transactions and requires individuals to report the sale, exchange, or other disposition of cryptocurrency on Form 1040.² In accordance with its guidance since 2014, the IRS treats cryptocurrency as property for federal income tax purposes, which means that gains or losses from sales and exchanges are subject to tax.³

Guidance on Deducting Crypto Losses

In January 2023, the IRS published a Chief Counsel Advice on when taxpayers can and cannot claim deductions for cryptocurrency losses.⁴ The memorandum states that taxpayers cannot claim a deduction on personal investments of cryptocurrency when the value substantially declines but is still greater than zero and continues to be traded on at least one cryptocurrency exchange. The underlying assumption is that the taxpayer did not sell, exchange, dispose, or abandon the cryptocurrency tokens. However, if the decrease in cryptocurrency value is realized by a completed transaction, which determines the amount of loss, then the loss is allowed as a deduction for the taxable year in which the loss was sustained. Moreover, if the taxpayer provides supporting evidence to demonstrate that the cryptocurrency tokens are worthless or abandoned, a deduction can be claimed under §165. In practical terms, events including (1) cryptocurrency protocols getting hacked and tokens stolen from individuals (e.g., Axie Infinity’s Ronin Bridge hack) and (2) an individual burning their tokens (i.e., sending them to the null address) are qualified as tax events where taxpayers can claim a deduction related to the crypto tokens that they own.

Legal Tender Status in Some Foreign Jurisdictions

In April 2023, the IRS modified its 2014 guidance on cryptocurrency to recognize that virtual currency can have legal tender status in foreign jurisdictions.⁵ An example of a convertible virtual currency is Bitcoin, which is currently accepted as legal currency in two countries: El Salvador and Central African Republic (CAR).

The IRS acknowledged that:

In certain contexts, virtual currency may serve one or more of the functions of ‘‘real’’ currency — i.e., the coin and paper money of the United States or of any other country that is designated as legal tender, circulates, and is customarily used and accepted as a medium of exchange in the country of issuance — but the use of virtual currency to perform ‘‘real’’ currency functions is limited.⁶

Protocol Upgrade Not a Taxable Event

During the same month, the agency released a memorandum regarding the tax consequences related to cryptocurrencies native to blockchains that undergo a protocol upgrade.⁷ One of the main reasons behind this guidance was the plan for the Ethereum blockchain to become more energy efficient and upgrade from a proof-of-work mechanism to a proof-of-stake consensus. This major event (called “The Merge”) in the biggest blockchain network for smart contracts took place in September 2022. The IRS guidance clarified that the protocol upgrade event does not trigger gross income for tax purposes under §1001. The taxpayer still holds the same number of tokens as before the protocol upgrade, where no exchange of crypto tokens took place. In addition, the protocol upgrade does not result in gross income under §61(a). There has not been any inclusion of income for the taxpayer because the blockchain event did not produce an economic benefit in the form of cash, services, or other assets.

Furthermore, the most recent upgrade in the Ethereum network was the Shanghai/Capella upgrade that occurred in April, and the upgrade gave its validators the ability to withdraw staked coins and, as a result, increase liquidation. Staking rewards are normally considered income, but the upgrade is not necessarily a taxable event unless the investors withdrew (partial or full withdrawal) staked ETH, where one cryptocurrency was swapped for another (e.g., stETH swapped for ETH). Taxable income may be triggered on a protocol change if the holder receives property such as additional units as part of the change.

NFT Treatment as Collectibles

In March 2023, the IRS provided preliminary guidance⁸ to treat certain NFTs as collectibles, where a collectible is defined as any tangible personal property which is capital gain property and which is held by the taxpayer for more than 12 months primarily for the appreciation of its value. A consequence of this guidance is the higher capital gains tax rate for NFT sales, increasing to 28% from the previous 20%, which applies to most other types of capital gain assets.

The guidance refers to §408(m) in the context of collectibles within an individual retirement account and §1(h) as to long-term capital gains associated with such collectibles. The notice was issued pending further guidance and a request for comments on the definitions and analysis used, and taxpayer burdens they may impose.

Keep Abreast of IRS Guidance

The IRS guidance on taxation of digital assets is based on historical notions of what constitutes a taxable event, where a taxpayer either (1) received digital assets as a reward, award, or payment for property or services or (2) disposed digital assets through a sale, exchange, or transfer. Blockchain-based assets is an area where new technological innovations are frequently introduced, including protocol upgrades, hard fork events, bridge protocols, and more. The IRS provides this important guidance to address the ongoing changes in the world of digital assets. It is essential for taxpayers to be aware of the latest IRS memoranda related to digital assets. In some cases, taxpayers may need to reach out to an experienced professional to ensure they are compliant with the most recent IRS guidance on digital assets, and this is guidance we anticipate will evolve dramatically over time.

Originally published in Bloomberg Tax Memorandum.

1. §6045(g)(3)(D). It remains to be seen whether “virtual currency” must be reported on Form 8938 under the Foreign Account Tax Compliance Act, including assets held in “hosted wallets.” All section references are to Internal Revenue Code of 1986, as amended.
2. There are many issues surrounding bitcoin, cryptocurrencies, NFTs, and digital assets, including mining, barter, and charitable contributions, to name a few. This article focuses on a narrow subset of the issues. 
3. See Notice 2014-21, revised by Notice 2023-34 (cryptocurrency remains “property” for U.S. tax purposes even if El Salvador adopted it as a legal tender in 2021). See also Rev. Rul. 2019-24 (whether gross income results from a hard fork or airdrop event with respect to cryptocurrency) and the IRS' Frequently Asked Questions on Virtual Currency Transactions.
4. CCA 202302011 (Jan. 13, 2023) (a §165(g) loss is not available for digital assets because they are not listed as a “security” under §165(g)(2)).
5. Notice 2023-24, modifying Notice 2014-21. See also n.3, above.
6. Id. at 3, specifying the modification.
7. CCA 202316008 (Apr. 21, 2023) (the IRS continues to analyze cryptocurrency using historical tax concepts, though this may change in the future).
8. Notice 2023-27.