Aug 15 Stablecoin may NOT be So Stable Anymore
A cryptocurrency is a decentralized virtual currency, also known as a digital asset. Cryptocurrency is secured by cryptography and is designed to exist outside the control of a government or any other central authority. The freedom that cryptocurrencies offer comes with a price: high volatility triggered by sudden changes in supply and demand.
As the multicellular organism of cryptocurrencies evolved, in 2014, “stablecoins” were created. A stablecoin is a type of cryptocurrency intended to absorb volatility by pegging each coin to a real-world currency, also known as a “fiat currency.” Unlike original cryptocurrencies (BTC, ETH, etc.), stablecoins are considered more centralized since there is a company behind the scenes maintaining their pegs.
There are two ways for a stablecoin to maintain its peg, either with collateral or through an algorithm. A stablecoin can gain trust through collateral, whereby the coin is backed up by some kind of asset which supports the value of the coin. The most common collateral is the U.S. dollar. In general, 1 stablecoin equals $1 U.S. dollar.
Another way a stablecoin can maintain its peg is through an algorithm. When a stablecoin has an algorithmic peg, its company creates a smart contract containing a set of rules to guide the increase or decrease in the amount of circulating stablecoins depending on the coin’s price.
For example, one stablecoin may start with a value equivalent to $1 U.S. dollar but as more crypto owners buy-in, one stablecoin could be worth $1.20 U.S. dollars. In order to retain the coin’s peg, the company will mint (or generate) more coins, and this increase in supply will alleviate the price pressure and maintain the coin’s value at $1 U.S. dollar. This scenario will be reversed if crypto investors sell their stablecoins; meaning that if more coins are sold, the algorithm will burn (permanently remove coins) based on the fluctuating demand to keep one stablecoin worth $1 U.S. dollar.
Like all other investments, cryptocurrencies have been experiencing significant losses due to inflation and economic uncertainty. The most recent hit in the cryptomarket was the crash of algorithmic stablecoin TerraUSD and its sister coin Terra (LUNA). Last May, TerraUSD lost its peg to the U.S. dollar and collapsed almost 100%, causing a devastating loss across the cryptomarket.
The near wipeout of TerraUSD and LUNA coins cost many investors millions of dollars. The assets of Binance, the world’s largest cryptocurrency exchange by daily trading volumes, in Luna fell to just $2,200 from $1.6 billion.
This precipitous fall could mean that taxpayers may need to recognize a complete loss of their entire investment in the stablecoins. That is to say, while stablecoins sold after a crash could result in reportable capital losses, where there is no longer a market for these assets, selling these coins could be difficult or impossible.
Taxpayers finding themselves in this situation may discover that they are restricted by law from deducting losses stemming from worthless stablecoins until they can be sold or disposed of completely. The IRS does only allow loss deductions for securities that become worthless during the year under IRC Sec.165 but only if the security is considered a capital asset in the taxpayer’s possession.
Under IRC Sec. 165(g)(2), securities are defined as: “a share of stock in a corporation; a right to subscribe for, or to receive, a share of stock in a corporation; or a bond, debenture, note or certificate, or other evidence of indebtedness, issued by a corporation or by a government or political subdivision thereof, with interest coupons or in registered form.”
Since stablecoins do not meet the letter of this statute, it appears that without legislation, or possibly additional clarification from the IRS, taxpayers might be precluded from taking advantage of the deductions under IRC Sec. 165. In other words, if there is no market to sell a stablecoin whose value has plummeted, there may be no mechanism as a matter of current tax law for a taxpayer to deduct the loss.
Recently, Congress introduced a Digital Asset Bill dubbed the “Digital Commodity Exchange Act of 2022,” (the “DCE Bill”) which, importantly, designates digital currencies as “ancillary assets.” It would allow digital currencies to be treated as “commodities” under U.S. law under the oversight of the Commodity Futures Trading Commission (CFTC), unless any such currency behaves more like a security. In other words, the DCE Bill would treat most cryptocurrencies like commodities but those which are issued by a corporation to build capital and provide the investor’s privileges like dividends, liquidation rights, financial interest in the issuer, etc. would be treated as securities.
All of this to say that it seems taxpayers – and their advisors – might have a long battle to conquer if they want to take the position that their stablecoins are “securities,” eligible for a tax loss which is calculated as if the stablecoins were hypothetically sold at the end of the year when it becomes worthless.
The crypto market is well in a bear season, but faithful investors still believe that the market will bounce back. Peter Smith, CEO of Blockchain.com, says, “More pain is coming, more risk will be exposed, but ultimately, it’s a good thing for the decentralized economy. ‘Creative destruction’ is ultimately helpful in consolidating the crypto economy.” Source: CNBC.com
About the Authors
Mayank Shah, CPA is a Senior Tax Manager at Sax and a vital member of the firm’s M&D and Cryptocurrency Practices, assisting clients with accounting, tax, and financial advisory that are unique to the industries. His areas of expertise include tax compliance, tax strategies, tax planning and additional advisory services. He can be reached at [email protected].
Jamie J. Torres is a Senior Associate at Sax and specializes in cryptocurrency, and high-net-worth clients. As a member of the Sax Cryptocurrency Practice, Jamie works closely with cryptocurrency investors, NFT creators, miners, and other clients in the decentralized community. Her undertaking is to engage in the changing regulatory landscape of virtual assets to help both individuals, and business owners understand how taxable events are triggered by cryptocurrency-related transactions. She can be reached at [email protected].