Tax Benefits Available For Victims Of The Crypto Crash And Scams
Investors who lost money on cryptocurrency have some ways to reduce their tax bill but it will depend on their own facts and circumstances.
Last year was probably the worst year for crypto investors, as many cryptocurrencies have lost significant value for various reasons. Several large crypto companies filed for bankruptcy, and some are also being investigated for possible civil and criminal violations. Their customers’ crypto assets are being held in the bankruptcy estate, and it is uncertain when and how much they will get back. Others have been victims of online scams where the perpetrators are overseas, and the chances of them getting their money back are almost impossible.
Today’s column will look at whether these investors and victims could get some tax relief due to their losses.
The basic rule is that cryptocurrencies sold at a loss are treated as capital losses. This generally means that capital losses can offset capital gains realized in the same year and up to $3,000 of ordinary income. For noncorporate taxpayers, they cannot carry back the loss to offset prior capital gains and receive a tax refund. But the losses can be carried forward indefinitely under current law.
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Abandonment and Worthlessness. A common problem for crypto holders is that when a coin crashes, its value can be minuscule to the point where it becomes unsellable. It is common for cryptocurrencies to be valued at fractions of pennies, and finding a buyer in the open market could be difficult. So taxpayers may be tempted to take a loss by declaring their cryptocurrencies worthless or abandoning them.
Unfortunately, the Internal Revenue Service’s Office of Chief Counsel recently released a memorandum stating that taxpayers cannot take a deduction on worthless or abandoned cryptocurrencies.
The memo stated that a cryptocurrency is not worthless so long it had liquidating value and continues to be traded on at least one exchange, which makes it possible that the value may increase in the future.
Interestingly, it also stated that the taxpayer cannot take a worthlessness security deduction under Section 165(g) of the Internal Revenue Code because it believes cryptocurrencies are not securities. Section 165(g)(2) defines a security as a share of stock in a corporation; a right to subscribe for, or to receive, a share of stock in a corporation; or bond, debenture, note, or certificate, or other evidence of indebtedness issued by a corporation or government.
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As for abandonment, the Service’s opinion is that a taxpayer has to take affirmative steps to show abandonment of the property in order to claim the deduction. If the taxpayer exerts dominion and control of the cryptocurrency and has the ability to sell, exchange, or otherwise dispose of it, then it is not considered abandoned.
Finally, even if there is a worthlessness or abandonment loss, such losses are considered miscellaneous itemized deductions. The Tax Cuts and Jobs Act repealed miscellaneous itemized deductions from 2018 to 2025.
In light of the above, taxpayers wanting to claim a loss will have to take steps to sell the property, even if it is for literally pennies. It should not be hard to find a buyer for that price.
Crypto assets held in bankruptcy estate. If a crypto business has filed bankruptcy, its assets will be held in the bankruptcy estate until the court decides on how creditors will be paid. It appears that customers will be treated as general unsecured creditors which means they will be the last to be paid from the remainder of the estate, which will likely be pennies on the dollar. Generally, the loss deduction cannot be claimed until the determination has been made.
The problem for taxpayers in this situation is that they have limited planning options since they are not in control of the bankruptcy proceedings. They may opt to sell their claims to a third party if possible.
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Theft loss. Claiming a theft loss deduction is an attractive option because under certain conditions, it can offset ordinary income and excess losses can be carried forward indefinitely as a net operating loss.
Sadly for some, claiming the theft loss is their only hope for avoiding a tax bill on top of a huge economic loss. Some people have taken out money from their tax-advantaged retirement accounts to purchase cryptocurrencies as investments. They will have to pay ordinary income taxes on the withdrawal and if capital losses are claimed on the disposal of the cryptocurrency, it can only offset $3,000 of the ordinary income.
To claim the theft loss, the taxpayer must be able to show that there was a taking of money or property with the specific intent to deprive the owner of it. The taking must be illegal under the law of the state where it occurred and must have been done with criminal intent. Also, there has to be no reasonable expectation of recovery from a third party or insurance.
A drop in value of an asset is not enough to establish theft. Some of the more infamous crypto promoters have denied acting fraudulently, so it will take other evidence to show the requisite criminal intent.
Also, theft of personal-use property is not deductible from 2018 until 2025 unless the loss is attributable to a federally declared disaster.
Lastly, if the transaction was done through a brokerage or exchange, then the theft loss deduction will be denied unless the perpetrator used it as a conduit.
Despite the limitations, the good news is that the IRS seems to recognize that crypto thefts are not necessarily losses of personal-use property. In the above memo disallowing the worthlessness and abandonment loss, a footnote stated that casualty and theft losses are subject to special rules, citing Revenue Ruling 2009-9. That ruling stated that if a taxpayer entered into a transaction for profit, the theft loss is not considered a personal-use property loss and is not subject to the limitations described above.
Investors who lost money on cryptocurrency have some ways to reduce their tax bill but it will depend on their own facts and circumstances.
For those living in Southern California, I will be giving a presentation to the Pasadena Bar Association’s Tax Section on this subject in more detail on February 17th. More details can be found here, and CLE credit will be provided to those who attend.
Steven Chung is a tax attorney in Los Angeles, California. He helps people with basic tax planning and resolve tax disputes. He is also sympathetic to people with large student loans. He can be reached via email at stevenchungatl@gmail.com. Or you can connect with him on Twitter (@stevenchung) and connect with him on LinkedIn.
