Crypto investors are likely to get tax write-offs from assets held on insolvent exchanges, but they are probably going to have to wait a while. Exchanges simply freezing withdrawals (or even declaring bankruptcy) is not enough. The assets must be deemed fully worthless and totally unrecoverable before you can take the deduction.
Exchange Failures Abound
Voyager and Celsius have both declared bankruptcy and other exchanges are likely to follow suit. Based on statements from both companies – along with the basic nature of bankruptcy filings – it is very unlikely that investors who held crypto on either exchange will receive all of their funds back. How much they will receive, if they receive anything at all, is still unclear.
Knowing that they are all but guaranteed to suffer some kind of loss from these exchange insolvencies, crypto investors are wondering if they can get a tax write-off for the assets held on these platforms.
The answer is that they likely will get write-offs, but not as quickly as they might hope.
There are two issues that arise within these situations:
- The debt must be completely worthless and unrecoverable
- The exact amount of loss has to be known
When an exchange “temporarily” pauses withdrawals (even if we know how that story is likely to end), that action on its own does not have the finality the IRS requires for you to be able to write off the bad debt.
Note: this is the second time we have used the term debt already in this article. That is not by mistake. While they present themselves as custodians of your funds, some exchanges specifically note in their terms that the funds you deposit are loans you are making to the platform. And your most likely method of writing these losses off on your tax return will be as nonbusiness bad debt.
Even Bankruptcy Filing Is Not Enough
But what about if an exchange files for bankruptcy? Surely that’s enough of a nail in the coffin to be able to take the write-off, right?
Not quite. Most of these exchanges are filing for Chapter 11 bankruptcy, which means they are trying to reorganize and hope to continue operations. Those filings are a very bad sign for the company, as only 10-15% of Chapter 11 filings are ultimately successful, but they are still not final. The company could, in theory, recover and you receive some or all of your assets back.
There is also the fact that account holders are likely to receive something from these bankruptcies, but it is unclear how much or when they will receive it. In Voyager’s bankruptcy filing they said that:
“Each Holder of an Allowed Account Holder Claim will receive in full and final satisfaction, compromise, settlement, release, and discharge of such Allowed Account Holder Claim, its Pro Rata share of:
- the Coin Allocation;
- the Claims Equity Allocation;
- the Voyager Token Allocation; and
- the 3AC Recovery Allocation”
Three Arrows Capital (3AC) alone owes Voyager over $650 million. Voyager could recover some, all, or none of that loan. That outcome will make a significant difference in the level of recovery account holders will receive.
Unfortunately, this is likely to drag out for some time. So crypto investors aren’t going to be able to take these write-offs nearly as quickly as they would probably like. They may have to wait a good while before they are actually able to take the deduction on their tax return.
How to Claim the Deduction on Your Tax Return
But what about whenever the bankruptcy filings are complete, or it otherwise becomes clear that the loss is final? How do you actually take the deduction?
Assuming there is an actual creditor-debtor relationship (which will be the case for the majority of these exchanges but would need to be examined on a case-by-case basis), then you would write the losses off as nonbusiness bad debts.
Importantly, you are only able to write off your cost basis in the lost tokens, not their FMV when the exchange seized them.
As an example, let’s say you bought one Bitcoin when it was $5,000. An exchange freezes withdrawals when BTC is worth $50,000. And when it is determined that the debt is completely worthless and nonrecoverable (which is when you are allowed to take the deduction), the price of BTC was $20,000.
Which amount do you write off? The $5,000, $20,000, or $50,000?
Unfortunately, you are only able to write off your $5,000 cost basis – not the 10x price when withdrawals were frozen or the 4x price when the debt became completely worthless.
The IRS instructs that you take this deduction “as a short-term capital loss on Form 8949, Sales and Other Dispositions of Capital Assets, Part 1, line 1.” They also note that you will need to “enter the name of the debtor and “bad debt statement attached” in column (a). Enter your basis in the bad debt in column (e) and enter zero in column (d).”
Conclusion: Try to Avoid These Losses Entirely
Getting a tax deduction is not the same as getting your money back. Unlike tax credits (which reduce your tax on a dollar-for-dollar basis), you are only getting a percentage of what you lost with a tax deduction.
It sounds basic – and to a large extent it is – but the easiest way to preserve your capital is to avoid having your money on platforms that could go insolvent. With the market turbulence we’re experiencing right now, the benefit of higher deposit rewards is just not worth the risk of losing your crypto entirely. Only interact with financially robust exchanges and try to keep as much as possible in cold storage.
Keeping your assets in a self-custody wallet has its own risks. If you fall for a phishing scam or someone gets access to your seed phrase, your crypto is lost. There is no support team to reach out to help you recover your funds. That crypto is completely gone. But you also don’t have the risks of the platform going completely belly up and you’re left holding the bag.
Good and bad, you’re entirely on your own with self-storage. So make sure you’re following security best practices and are keeping your assets safe.
Any accounting, business, or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.
