There is no clear consensus on whether or not crypto investors are able to take casualty or theft losses for funds held on defunct crypto exchanges. Many experts say it is not allowed under the 2018 Tax Cuts and Jobs Act (TCJA) revisions, while others point to special provisions outlined in 2009 for victims of Ponzi schemes.
FTX declared bankruptcy last week – making it the third major centralized exchange to do so in this year alone. This follows the near complete collapse of Terra Luna/UST and the nearly $60 billion of market cap that it wiped out. Following FTX’s announcement, BlockFi has also announced that they are pausing withdrawals.
While these failures are becoming regrettably common during this bear market, FTX’s failure feels different in a couple of key ways. FTX was the second largest exchange in the world. And while details are still emerging, initial reports show what at least appears to be fraudulent intent on the part of both FTX and Alameda Research. It is also notable because Sam Bankman-Fried had become a bit of a crypto darling to Congress – having testified before them multiple times pushing for increased regulations in the space and even lobbying against DeFi. A bit comically, he gave this testimony citing the need to protect customer deposits.
But from the tax side, it renews a question that came up quite a bit after the Voyager and Celsius failures: are you able to write off the losses as a casualty or theft loss on your tax return?
Interestingly, the answer may be different with FTX than it was for these other failures.
Why?
TJCA Limited Casualty and Theft Loss Deductions
Prior to the tax code being revised in 2018, you were able to deduct casualty and theft losses as an itemized deduction on your tax return. This was largely eliminated with the TJCA, which limited these losses to federally declared disasters. Because of this, if you look at most of the guidance from tax professionals, they will simply say that you cannot take the loss on Form 4684.
And for the majority of exchange failures, they would be right. In fact, they may even be right across the board.
But there are some special provisions out there for victims of Ponzi schemes that may be relevant with the FTX failure and others like it. Even Publication 547 (which specifically covers casualty, disaster, and theft deductions and their limitations) notes “the personal-use property limitation for tax years 2018 through 2025 does not apply to losses on income-producing property, such as losses from Ponzi-type investment schemes.”
So what is the difference?
Fraudulent intent.
Ponzi Scheme Exceptions
After Bernie Madoff’s Ponzi scheme fell apart, the IRS released Revenue Ruling 2009-9. This was designed to provide tax relief to the victims of that scheme and others like it.
In this ruling, the IRS outlines a taxpayer (“A”) who deposits funds with someone who claims to be an investment advisor (“B”). After eight years, it is discovered “that B’s purported investment advisory and brokerage activity was in fact a fraudulent investment arrangement known as a “Ponzi” scheme.”
Very important for our discussion here, this guidance states that:
“B‘s actions constituted criminal fraud or embezzlement under the law of the jurisdiction in which the transactions occurred. At no time prior to the discovery did A know that B‘s activities were a fraudulent scheme.”
So in these cases, you have an individual who invested funds with the express purpose of making a profit, but was swindled by a fraudster.
As always, the entire revenue ruling is worth reading, but we’re going to include some of the more pertinent portions below (bolding for emphasis ours):
“For federal income tax purposes, “theft” is a word of general and broad connotation, covering any criminal appropriation of another’s property to the use of the taker, including theft by swindling, false pretenses and any other form of guile. Edwards v. Bromberg, 232 F.2d 107 (5th Cir. 1956); see also § 1.165-8(d) of the Income Tax Regulations (“theft” includes larceny and embezzlement). A taxpayer claiming a theft loss must prove that the loss resulted from a taking of property that was illegal under the law of the jurisdiction in which it occurred and was done with criminal intent. Rev. Rul 72-112, 1972-1 C.B. 60. However, a taxpayer need not show a conviction for theft. Vietzke v. Commissioner, 37 T.C. 504, 510 (1961), acq., 1962-2 C.B. 6.
The character of an investor’s loss related to fraudulent activity depends, in part, on the nature of the investment. For example, a loss that is sustained on the worthlessness or disposition of stock acquired on the open market for investment is capital loss, even if the decline in the value of the stock is attributable to fraudulent activities of the corporation’s officers or directors, because the officers or directors did not have the specific intent to deprive the shareholder of money or property. See Rev. Rul. 77-17, 1977-1 C.B. 44.
In the present situation, unlike the situation in Rev. Rul. 77-17, B specifically intended to, and did, deprive A of money by criminal acts. B’s actions constituted a theft from A, as theft is defined for § 165 purposes. Accordingly, A’s loss is a theft loss, not a capital loss.”
Unlike other exchange failures that have occurred from overleveraging and adverse market conditions, the details emerging from the FTX failure at least appear to indicate that specific fraudulent intent. As noted in Revenue Ruling 77-17, fraud simply being committed by officers or directors (and a subsequent loss resulting from it) is not in and of itself sufficient. Their intent to defraud is a material factor.
When Can You Take the Theft Deduction?
In the IRS’s example, the fraud had been occurring for multiple years. When can you claim the deduction? And if the Ponzi has been generating “income” that you have been claiming on your tax returns for all of those years, are you required to go back and amend all of those prior tax returns now that it is clear that there was no income actually being generated?
Thankfully, no. These losses are able to be taken in the year the theft was discovered, not when they actually occurred. However, there is a limitation to this. If there is a portion of the loss for which there is a “reasonable prospect of recovery”, that portion of the loss should be excluded until there is more clarity. RR 2009-9 notes:
“Section 165(e) provides that any loss arising from theft is treated as sustained during the taxable year in which the taxpayer discovers the loss. Under §§ 1.165- 8(a)(2) and 1.165-1(d), however, if, in the year of discovery, there exists a claim for reimbursement with respect to which there is a reasonable prospect of recovery, no portion of the loss for which reimbursement may be received is sustained until the taxable year in which it can be ascertained with reasonable certainty whether or not the reimbursement will be received, for example, by a settlement, adjudication, or abandonment of the claim. Whether a reasonable prospect of recovery exists is a question of fact to be determined upon examination of all facts and circumstances.”
How Much Can You Deduct?
You are allowed to write off your cost basis in the property, less any reimbursements or other compensation you receive. Any amount you reported as income in prior years is also deductible:
“Section 1.165-8(c) provides that the amount deductible in the case of a theft loss is determined consistently with the manner described in § 1.165-7 for determining the amount of a casualty loss, considering the fair market value of the property immediate after the theft to be zero. Under these provisions, the amount of an investment theft loss is the basis of the property (or the amount of money) that was lost, less any reimbursement or other compensation.
The amount of a theft loss resulting from a fraudulent investment arrangement is generally the initial amount invested in the arrangement, plus any additional investments, less amounts withdrawn, if any, reduced by reimbursements or other recoveries and reduced by claims as to which there is a reasonable prospect of recovery. If an amount is reported to the investor as income in years prior to year of the discovery of the theft, the investor includes the amount in gross income, and the investor reinvests the amount in the arrangement, this amount increases the deductible theft loss.”
How to Claim the Deduction?
If you meet the required criteria, you will claim the theft deduction the same way you would other theft losses using Form 4684 and Schedule A.
There is an optional safe harbor procedure you can use as well, which was outlined in Revenue Procedure 2009-20. This procedure was released concurrently with Revenue Ruling 2009-9 and is even grouped together on the IRS’s website on “Help for Victims of Ponzi Investment Schemes”. In order to elect this option, it is required that the lead figure:
“was charged by indictment or information (not withdrawn or dismissed) under state or federal law with the commission of fraud, embezzlement or a similar crime” or “was the subject of a state or federal criminal complaint (not withdrawn or dismissed) alleging the commission of a crime described in section 4.02(1) of this revenue procedure”.
Note that in both cases, conviction is not required – simply that they are charged and the complaint has not been withdrawn. If you elect that option, your deduction is limited to 95% of your losses if you are not pursuing any sort of third-party recovery and 75% if there is a potential third-party recovery in play.
Conclusion: Keep Your Funds Safe
If your losses do not meet the above criteria, your best avenue of recourse is likely to claim it as non-business bad debt, which we covered in our previous articles discussing the Celsius and Voyager bankruptcies.
But as we noted in that article, these deductions do not make you whole. You are only recovering a portion of the funds lost. Especially with the current turbulence in the market and lack of regulation in the space, no exchange is truly safe. Shark Tank investor Kevin O’Leary famously said just last month that “if there’s ever a place I could be that I’m not gonna get in trouble, it’s gonna be at FTX.”
Now more than ever it is important to keep your funds safe. Until there is more regulation on centralized exchanges and transparency required on how/where they keep customer funds, there is always going to be some risk keeping your crypto on exchanges. The benefit – if not downright necessity – of keeping your funds in cold storage (and keeping those private keys somewhere secure) has never been greater.
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.
