The threat of losing your crypto investment can be terrifying. Unfortunately, there is an ever-growing number of people losing crypto investments they thought were secure - be it due to stolen wallets, sending crypto to the wrong recipient, or exchanges collapsing. 

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Let’s examine the following steps to determine if any fiscal recompense may be available to soften the blow of such unexpected and unwelcome losses.

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Was your crypto a debt or non-debt instrument?  

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Crypto is presently deemed to be property for US tax purposes. Accordingly, the tax deductibility of such losses largely depends on whether the lost property was a debt or non-debt instrument. 

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Non-Debt Instrument

If you or an exchange were simply the custodian of crypto that was a non-debt instrument, then you may not be eligible for certain tax deductions due to changes set forth in the 2017 Tax Cuts and Jobs Act, which eliminated deductions for casualty losses or losses due to theft, unless they were the result of a federally declared disaster. However, if it can be characterized as an investment loss, then it may be deductible. 

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Debt Instrument 

The loss of debt instruments may be eligible for a tax deduction.  However, in order for lost crypto to qualify for such a deduction, a genuine debt must have been extended to another party. For example, crypto loaned to a platform or exchange for example, will satisfy the debtor-creditor requirement. 

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However, determining whether you have actually made a loan or not to an exchange can be less than straightforward. If the platform’s terms and conditions aren’t entirely clear about whether crypto transferred to the exchange constitutes a loan or not, then also consider facts such as whether you are earning any kind of return or reward in exchange for the platform holding your crypto, as that may be indicative of a debitor-creditor relationship.

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Has the asset or debt balance truly become worthless?

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In order to claim a tax deduction for lost crypto, the property must truly be entirely and irrevocably lost. Partial losses won’t suffice, just as crypto platforms freezing accounts or limiting withdrawals won’t cut it either. Of course, in the event that frozen accounts and withdrawal limitations ultimately result in a complete loss of your crypto assets, or if the platform declares bankruptcy and discharges the debt, then a tax deduction for the loss is a possibility.

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What kind of deduction is available, if any?

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Casualty & Theft

Since the passage of the 2017 Tax Cuts and Jobs Act, deductions for casualty losses and losses due to theft have mostly been eliminated, unless they were the result of a federally declared disaster. At present, this Act is effective until 2025. During this period, losses as a result of sending crypto to the wrong address, losing access to hardware or software wallets, or crypto stolen via hacks, malware or physical theft cannot be claimed for tax purposes.

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Investment Losses

While downturns in the value of crypto can set investors up for tax loss harvesting, there is less scope of tax deductions when your crypto has been lost or stolen - and, as everywhere in crypto, there is a lot of grey area. However, there are some opportunities for investment loss deductions.

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A rug pull is a specific kind of scam which tends to qualify as an investment loss, which means victims of such scams can deduct the resulting losses. In a rug pull, a new coin is created and hyped. Once the token reaches a (relatively) high value, the coin creator disappears with all investor funds. This scam doesn’t tend to fall into the casualty loss or theft categories, as the taxpayer still holds the tokens (i.e. they still hold the asset - it’s just been rendered worthless). 

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Alternatively, if your crypto was a bonafide loan to a platform, and that platform collapsed, then the taxpayer can claim the cost basis of the loan as a short-term capital loss pursuant to the non-business bad debt deduction. 

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Casualty & Theft vs. Investment Losses

Tax professionals debate the treatment of non-debt crypto lost due to the collapse of exchanges, as well as scams. In the absence of clear guidance from the IRS, there are strong positions arguing them to be casualty losses, which no longer give rise to tax deductions, as well as points of view arguing them to be deductible investment losses. While foregoing the tax deductions would be the most conservative response to this uncertainty, it’s clearly not the best outcome for the taxpayer who is already bearing the sting of losses. 

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As always, consult your tax advisor to determine the best course of action in your specific situation.

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Can losses be carried forward?

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If you can claim your losses, then any unused portion of the loss can be carried forward to future years. With respect to investment losses, such as rug pulls and loans to exchanges, the deduction allows some immediate benefit in the current tax year, as a short-term capital loss. These losses can be deducted to offset any capital gains and up to $3,000 of ordinary income in a given tax year. If your losses exceed these amounts, then they can be carried forward to future tax years to offset future gains and up to $3,000 of ordinary income.

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Are you a Web3 Enterprise and want to learn how Fyn can help you navigate the new crypto tax market? Schedule a call with us today!