What the Terra Luna Collapse Means for Your Crypto Taxes

It’s not been a good week for crypto traders as a whole, but it’s been a horrendous week for holders of algorithmic stablecoin Terra (UST) and its sister coin LUNA. With the market at two-year lows and many UST or LUNA holders struggling to sell their worthless or near-worthless assets, many are wondering if and how they can realize crypto losses on their taxes. 

In this blog, we’ll discuss several common scenarios that traders are facing, how each one may affect crypto taxes, and both Luna tax and Terra tax consequences in light of the situation.

If you were able to sell UST or LUNA before it lost all value, you should report the sales as capital losses on your income taxes. You can use them to offset up to $3,000 of ordinary income and can offset an unlimited amount of capital gains. Capital losses are reported on Form 8949 and Schedule D. 

Additionally, you will be able to carry forward losses. So, even if you had an overall capital loss in 2022 and can’t use losses to offset gains, you will be able to carry forward those losses to future years in which you have overall gains. Losses can be carried forward indefinitely. 

In a given tax year, the amount of losses you can carry forward is the amount of your total net loss that is more than your allowable capital loss deduction for the year or your taxable income increased by your allowable capital loss deduction for the year. IRS Worksheet 4-1 can help you determine this amount. 

If you weren’t able to sell your LUNA before it lost its value, your position is trickier. Typically, you have to be able to sell or swap crypto in order to realize a loss so you can claim it on your taxes. If there’s no market for your assets, this can be difficult or impossible.

The IRS allows tax deductions for worthless securities that are considered capital assets. While cryptocurrencies are often capital assets, the SEC has not officially ruled that they are securities. However, a 2017 decision concerning The DAO’s governance tokens and recent comments by SEC Chair Gary Gensler could suggest that in the future, some digital assets may be classified as securities. 

Taking this into consideration, there may be an avenue for deducting worthless LUNA from your income taxes. At the time of writing, LUNA is trading at $.0001 (5/16/22) and might be considered worthless—depending on your crypto tax accountant’s guidance. Note: you must report the loss in the year the asset became worthless.

Because UST is trading for $.10 (5/16/22), it cannot yet be considered a worthless asset, but this may change in the days ahead.

To claim a worthless security on your taxes, you have to formally abandon it (relinquishing all rights to it) and/or provide documentation that it has no value, such as a letter from the company saying it has ceased operations.^[1]

26 CFR § 1.165-5 of the IRS tax code says the following:

(i) Abandonment of securities -

(1) In general. For purposes of section 165 and this section, a security that becomes wholly worthless includes a security described in paragraph (a) of this section that is abandoned and otherwise satisfies the requirements for a deductible loss under section 165. If the abandoned security is a capital asset and is not described in section 165(g)(3) and paragraph (d) of this section (concerning worthless securities of certain affiliated corporations), the resulting loss is treated as a loss from the sale or exchange, on the last day of the taxable year, of a capital asset. See section 165(g)(1) and paragraph (c) of this section. 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. For purposes of this section, all the facts and circumstances determine whether the transaction is properly characterized as an abandonment or other type of transaction, such as an actual sale or exchange, contribution to capital, dividend, or gift.

We recommend working with a crypto tax accountant to determine how to best fulfill these requirements. 

Even if you didn’t hold UST or LUNA, you’ve likely had sizable losses in your crypto portfolio. This might be a good time to consider crypto tax loss harvesting. This is a strategy in which assets are sold at a loss in order to lower one’s amount of taxable capital gains.

Crypto tax software makes this process easier.  For example, TokenTax’s Tax Loss Harvesting Dashboard can help you quickly identify these opportunities. 

If you're insolvent after the Terra Luna crash and don't think you will be able to pay your 2021 taxes, the IRS provides payment plan options. Note that if you apply for an IRS payment plan, you will need to provide them with full transparency to your finances, as well as pay any associated plan fees.