What are your options for reporting losses related to Bankrupt Exchanges?

Many investors want to know their options for taking a tax write-off related to funds locked on bankrupt platforms like Voyager, FTX, BlockFi & Celsius.

Tax write-offs can save you thousands of dollars in taxes. However, if you don’t handle them correctly, you will increase your chances of being audited by the IRS or have undesired results. Knowing how these write-offs work and when to apply them will help you avoid such pitfalls.

Deductibility of personal losses under the current tax code

The Tax Cuts & Jobs Act (TCJA), passed in 2017, significantly reduced your ability to write off personal losses on your taxes. Consequently, between January 1, 2018, and December 31, 2025, personal casualty & theft losses are deductible only if they are attributable to a federally declared disaster area. These losses typically include damages caused to your physical property by natural events such as floods, hurricanes, etc. Cryptocurrency-related casualty and theft losses are hard to deduct under this rule because it’s difficult to attribute them to federally declared disaster areas.

That said, there are a few provisions under which you may still be able to deduct losses related to insolvent exchanges when bankruptcy & other court proceedings are finalized. Let’s analyze them below.

Theft losses incurred in a transaction entered into for a profit

According to Reg 1.165-8(d), theft is (but is not limited to) larceny, embezzlement, and robbery. IRC 165(c)(2)allows taxpayers to report losses for any “transaction entered into for profit,” even if they are not connected to a trade or business.

What is a “transaction entered into for a profit”?

Luckily, the tax code still allows you to deduct theft losses (not attributable to federally declared disaster areas) if you incur them in a “transaction entered into for a profit” (IRC 165(c)(2)). Notably, TCJA does not prohibit these losses.

There’s no clear guidance on what constitutes a “transaction entered into for a profit.” This phrase is subject to interpretation and generally determined based on the facts and circumstances of each case. Based on past court cases, generally speaking, a “transaction entered into for a profit” must be entered primarily to make profits and is an actual “transaction.” The term “transaction” has been defined differently throughout history. It is conservative to assume that you should incur a loss in the actual transaction you entered into making a profit to be eligible for a deductible.

It is reasonable to say that most users engaged in trading activities on exchanges intending to make a profit. Therefore, if your situation falls within the definition of theft, you may be able to take a deduction as a theft loss incurred in a transaction entered into for profit.

The deductible portion of the theft loss depends on how much you anticipate receiving back. Reg 1.165-8(a)(2) provides details on reporting theft losses. The loss must be reported in the year it is discovered. However, if there is a claim to receive a form of compensation, you need to wait until the prospect of recovery no longer exists to claim a tax deduction.

Bunch v. Commissioner T.C. Memo 2014-177 highlighted this. Bunch initially took a bad debt deduction and tried to amend their 2006 return in 2009 to claim a theft loss for an investment loan they made to a mortgage company. They did this because the lead figure of the mortgage company was charged with wire fraud and pleaded guilty in 2009. The court stated that “a reasonable prospect of recovery will postpone the theft loss deduction until the prospect no longer exists.” The court denied their 2006 theft loss because a reasonable prospect of recovery existed in 2006. In addition, they did not provide enough evidence to prove that the lead figure was a thief (limited information was available in 2006).

What tax year do you report the loss?

According to Reg 1.165-8(a)(2), theft losses are reported in the year of discovery. Reg. 1.165-1(d)(2) mentions that if a claim for reimbursement exists (in simple terms, a way to recover your funds by any means), only the unrecoverable amount is deducted in the year you discover the theft. Any other amount will be deducted when there is no longer any prospect of recovery, as displayed by your particular facts and circumstances.

You may still report the theft, but you might not report a deduction. According to the Form 4684 instructions for line 21 (which tells you to go to Line 3 instructions), you enter the amount of reimbursement you received or expect to receive.

Example:

In 2022, you purchased crypto for $10,000. Later in 2022, the exchange holding the crypto filed for bankruptcy. Then in 2023, you discover that the company stole assets. You reasonably expect to receive full compensation because your proof of claim in the bankruptcy court is for the total amount. In 2024 you secure a judgment saying you will only receive $4,000. The timing and amount of your deduction will be as follows:

Tax year 2022 (Year of the theft event): $0

Tax year 2023 (Year of discovery): $0

Tax year 2024 (Year of deduction): $6,000 ($10,000 - $4,000)

Assuming the same facts, except you expect to receive 70% of the value ($7,000 ($10,000 x 70%)) in 2023, the year you discover the theft. The $3,000 ($10,000 - $7,000) is deducted in 2023 because that is the year you discovered the loss (even though it happened in 2022).

Tax Year 2022 (Year of the theft event): $0

Tax Year 2023 (Year of discovery & partial deduction): $3,000

Tax Year 2024 (Year of partial deduction): $3,000 ($10,000 - $3,000 - $4,000)

If you claim a deduction and later receive some compensation, you don’t need to amend the tax return you reported the deduction on. You may report any income to the extent it provided you with a tax benefit. If you didn’t receive any tax benefit from the loss, you don’t need to include it in your income.

Where do you report theft losses on my tax return?

Theft losses incurred in transactions entered into for a profit are reported on Form 4684, Section B, Part 1. After walking through the calculations, the allowable loss will flow to Schedule A, line 16, as an “Other itemized deduction” (not to be confused with miscellaneous itemized deductions, which TCJA disallows).

Note that you can only benefit from this deduction if you already itemize on your tax return and/or the theft loss is above your standard deduction amount (Single: $12,950. Married filing joint: $25,900).

Note: Theft losses are highly facts & circumstances driven. Therefore, it is crucial to examine the details of your case with a tax professional before taking this deduction.

Ponzi scheme losses

Rev. Rul. 2009-9 confirms that theft losses from fraudulent investment arrangements, known as a “Ponzi” scheme, are transactions entered into for profit. Rev. proc. 2009-20 provides an optional safe harbor deduction for taxpayers involved in a specified fraudulent arrangement. The definition of a specified fraudulent arrangement is where a party (lead figure) perpetrating the fraud receives cash or property from investors, purports to earn income for the investors, and reports income amounts that are wholly or partially fictitious. Payments, if any, of purported income or principal to investors are made from cash or property that other investors invested in the fraudulent arrangement.

This situation could apply to certain cryptocurrency-related situations that meet the criteria outlined in the Rev. proc. A lead figure must be charged with an indictment under federal or state law for fraud, embezzlement, or similar crime (Ex:Bitconnect). The same rules around the deduction timing still apply to a Ponzi scheme loss. A Ponzi loss is a subset of theft losses. The difference between theft and Ponzi losses is how you calculate the deduction.

How do you calculate a Ponzi scheme loss?

When calculating a Ponzi scheme loss, you will add your initial investment, subsequent investments, and income reported (before the discovery year), then subtract any withdrawals from all years. That net amount will be your total qualified investment. You will multiply your qualified investment by 95% if you have no potential third-party recovery. Next, you will subtract any actual recovery (not potential direct recovery) and potential insurance or Securities Investor Protection Corporation (SIPC) recovery. The difference between the total qualified investment and total recovery will be your deductible Ponzi loss.

Example:

Initial investment - $5,000

Subsequent investment - $900

Income reported - $100

Actual recovery - $0

Insurance or SPIC recovery - $0

The total qualified investment is $6,000 ($5,000 + $900 + $100).

Total qualified investment multiplied by 95% = $5,700 ($6,000 x 95%)

Less: recoveries - $0

Deductible Ponzi theft loss - $5,700

Where do you report a Ponzi scheme loss on my tax return?

Ponzi losses are reported on Form 4684, Section C. The deductible portion will flow to Schedule A line 16 as an “Other itemized deduction.”

Note that you can only benefit from this deduction if you already itemize on your tax return and/or the theft loss is above your standard deduction amount (Single: $12,950. Married filing joint: $25,900).

Casualty losses incurred in a transaction entered into for a profit

Casualty losses result from the damage, destruction, or loss of your property from any sudden, unexpected, or unusual event not willfully caused by you. A sudden event is swift, not gradual or progressive. An unexpected event is ordinarily unanticipated and unintended. An unusual event isn’t a day-to-day occurrence and isn’t typical of the activity you were engaged in.

IRC 165(c)(2) allows taxpayers to deduct losses incurred in “transactions entered into for profit,” even if it is not connected to a trade or business. A casualty loss is technically deductible if it occurs in a “transaction entered into for a profit,” despite the TCJA limitations.

Although casualty loss deduction is technically an option to deduct exchange-related losses, it is a hard one to prove. Casualty losses typically result in the destruction or damage to your property. This requirement is hard to meet because, in the case of a bankrupt crypto platform, the property isn’t necessarily destroyed.

Exchanges owe crypto (or an equivalent value) back to the users and have a debtor-creditor relationship with users. They didn’t destroy your property. The debtor-creditor relationship arose in Smith v. Commissioner, T.C. Memo 1979-76. Smith had a savings account at a credit union that went bankrupt. Smith claimed a casualty loss. The court denied the casualty loss deduction, stating that a credit union and its typical depositor of funds have a debitor-creditor relationship. Even if a casualty or theft caused the bankruptcy, the loss was from a debtor-creditor relationship governed by the bad debt provisions of IRC 166 (see below).

Casualty losses are deductible in the year you sustain the loss, which is generally in the year the casualty occurred. You haven’t suffered a loss if you have a reasonable prospect of recovery through a claim for reimbursement.

Where do you report casualty losses on your tax return?

If you take the approach that the loss is considered a casualty loss incurred in a transaction entered into for a profit, you can report it on Form 4684, Section B, Part 1. After walking through the calculations, the allowed loss will flow to Schedule A line 16 as an “Other itemized deduction.”

Note that you can only benefit from this deduction if you already itemize on your tax return and/or the theft loss is above your standard deduction amount (Single: $12,950. Married filing joint: $25,900).

Nonbusiness bad debt deduction

A nonbusiness bad debt (IRC 166(d)(2)) is a loss from the total worthlessness of a debt you extend to another party, like a cryptocurrency exchange or a lending platform.

The highlighted terms are critical. First, the debt must be totally worthless to be deductible under this provision. Generally speaking, debt is totally uncollectible and therefore worthless after you have tried every reasonable way to collect on it and have been unsuccessful. It’s also deemed worthless if the borrower files for bankruptcy and the debt is discharged. Reg 1.166-5(a)(2) also states that a loss on a nonbusiness debt is sustained only if and when the debt has become totally worthless, and no deduction shall be allowed for a nonbusiness debt that is recoverable in part during the taxable year. Therefore if there is any hope for recovery, you won’t be able to take a non-business bad debt deduction.

Second, you can only apply the nonbusiness bad debt deduction to debt instruments. In simple terms, a loan. In these bankruptcy cases, account holders are typically considered unsecured creditors, so it is reasonable to view your investment as a debt.

How do you report a nonbusiness bad debt deduction?

You can report a nonbusiness bad debt as a short-term capital loss (IRC 166(d)(1)(B)) on Form 8949 (Sales and Other Dispositions of Capital Assets), Part 1, line 1, and check box (C), “Short-term transactions not reported to you on Form 1099-B”, in the year it becomes totally worthless. The amount you can deduct is the initial value of your investment (cost basis).

Since this is a nonbusiness bad debt deduction, you must attach an additional statement (a bad debt statement) to your tax return.

The bad debt statement must contain the following:

1. A description of the debt, including the amount and the date it became due.
2. The name of the debtor and any business or family relationship between you and the debtor.
3. The efforts you made to collect the debt.
4. Why you decided the debt was worthless.

Bad Debt Statement Example:

John Doe - Social Security Number: 123-45-6789

Description of Debt: 1 bitcoin

Debt Amount: $10,000 (Total amount owed)

Due Date: On-Demand

Name of Debtor: Exchange X

Relationship: Unrelated third party

Efforts made to collect this debt: I made several attempts (explain and attach logs) to withdraw funds but failed.

Why this debt was worthless: The company declared bankruptcy on dd/mm/yyyy. Therefore, $10,000 is totally uncollectible and therefore worthless.

One important thing to note is that if you deduct the bad debt and collect all or part of it in a later tax year, you may have to include the amount you recovered in your gross income and pay taxes.

The status of bankrupt crypto exchanges

Voyager

On June 14, 2023, the Plan Administrator filed The First Status Report to Creditors. The plan enabled transfers during a 30-day period, which started around June 20, 2023. This plan allowed creditors to transfer crypto to another wallet. The initial recovery is 35.72% of a customer’s claim based on July 5, 2022 market prices. Voyager determined each cryptocurrency’s recovery price by taking the asset’s 24-hour volume weighted average price (VWAP) as of March 20, 2023. Here are a few examples from Voyager’s FAQs to illustrate the initial recovery amount.

Suppose creditors didn’t withdraw the allowed crypto during the 30 days. In that case, they will receive their recovery in US dollars at a later date. In addition, creditors may receive subsequent recoveries from the proceeds of various asset sales and litigation claims identified in the bankruptcy plan. The subsequent recoveries will be paid in US dollars by check.

FTX

FTX is in the middle of its bankruptcy proceedings, and there are several lawsuits against the founder, Sam Bankman-Fried. Since individuals have claims outstanding for all their holdings, a loss can’t be claimed until the case is settled. You can’t estimate the loss or deduct anything on your tax return until an initial judgment is made.

BlockFi

BlockFi would have been saved when FTX extended them a line of credit in June 2022. However, FTX’s collapse caused BlockFi to file for bankruptcy. Again, we must wait and see the judgment before deducting any losses. Once a ruling is made, any potential losses may be deductible in that year, depending on your specific facts & circumstances.

Celsius

Celsius filed for bankruptcy protection on July 13, 2022. Its situation is more complicated than other exchanges. You could have different results depending on the type of account you had with Celsius.

Earn Accounts

Celsius's Earn program allowed users to “deposit” their cryptocurrencies and receive interest payments. Based on the terms and conditions of this program, you loaned the cryptocurrency to Celsius. However, on January 4, 2023, the court ruled that Earn account assets are part of the bankruptcy estate. Therefore, individuals with Earn accounts are unsecured creditors; recovery of funds will depend on the distributions to unsecured creditors based on the bankruptcy plan. The IRS could argue that you disposed of your crypto when Celsius filed for bankruptcy, and they owe you the value of it at that time. The crypto belongs to the bankruptcy estate, not you.

Non-business bad debt deduction may be available if you do not recover any funds.

Example:

• You bought 1 BTC in 2020 for $5,000 and deposited it into Celsius in 2021.
• At the time of the bankruptcy, BTC's fair market value (FMV) was $20,000.
• You have a disposal of BTC and a gain of $15,000 ($20,000 - $5,000)
• Celsius files for bankruptcy. At the time it filed for bankruptcy (Snapshot time), 1 BTC was worth $20,000. You now have a debtor-creditor relationship with the Celsius bankruptcy estate for 1 BTC valued at $20,000.
• At the end of 2023, it becomes clear that you will only receive $0. The nonbusiness bad debt loss will be reported on your 2023 tax return as a short-term capital loss of $20,000 ($0 - $20,000).

Custody Accounts

Celsius’s custody program is different from its Earn program. Custody accounts are not considered part of the bankruptcy estate (Pg. 2). Celsius is authorized to allow withdrawals for customers with aggregate custody assets below $7,575. However, asset transfers between your Earn and Custody account 90 days before the bankruptcy filing impact your ability to withdraw funds.

What are your next steps?

As these cases move through the courts, you must stay current. Any new developments can change which deduction options are available to you when you can take a deduction, and how much you can deduct.

It is important that you maintain good records and discuss your specific situation with a tax professional before considering any deductions. It is also wise to file for an extension to give yourself more time to understand the outcome of your case.

If you don’t handle your situation correctly, you will increase your chances of being audited. Even when handled correctly, the IRS may still question your position because your tax return pops up from the majority of returns with no special deductions. In many cases, the overall cost associated with audits and correspondence with the IRS could outweigh the tax savings you get from obscure write-offs. Therefore, consult with your tax adviser to evaluate the pros and cons before committing to some of these write-offs.

If you have any questions or comments about crypto taxes, let us know on Twitter @CoinTracker.

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Disclaimer: This post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.