Victims of Crypto and NFT Fraud Can Take Theft Loss Deductions

Please fol­low and like us:
Pin Share

Bit­coin became a news sen­sa­tion in 2017, when its val­ue sky­rock­et­ed almost overnight to $20,000 per coin. A few years lat­er, the non-fun­gi­ble token also gained noto­ri­ety. Pro­mot­ers of NFTs claimed that their unique­ness would turn them into col­lectibles, cre­at­ing demand that would lead to a prof­it if they were lat­er sold.

Despite the poten­tial and promis­es, many cryp­tocur­ren­cies and NFTs have gone bust in recent months, with swaths of investors los­ing most, if not all, of the val­ue. In some cas­es, the cre­ators and pro­mot­ers were sim­ply unable to achieve the goals they promised. But oth­ers were scams in which the cre­ators had no inten­tion of repay­ing their investors and would dis­ap­pear after tak­ing the investors’ mon­ey, also known as rug pulls.

While most cryp­to and NFT fraud vic­tims will not get their invest­ments back, they may be able to take advan­tage of tax ben­e­fits due to their loss­es. The most ben­e­fi­cial is the theft loss deduc­tion, which can be used to off­set ordi­nary income, although the Tax Cuts and Jobs Act has lim­it­ed its use for per­son­al losses.

The IRS’ defin­i­tive guid­ance con­cern­ing the US tax treat­ment of cryp­tocur­ren­cy is in Notice 2014–21. It states that, in gen­er­al, such cur­ren­cy is treat­ed like prop­er­ty, so the price paid for the cryp­tocur­ren­cy becomes the cost basis. If it is lat­er sold, there is a cap­i­tal gain or loss on the trans­ac­tion. This notice is like­ly to apply to NFT trans­ac­tions as well. Unfor­tu­nate­ly, some tax­pay­ers will not be hap­py with tak­ing a cap­i­tal loss, as they may not have cap­i­tal gains to off­set the loss­es. They also may pre­fer to deduct the loss against their ordi­nary income, par­tic­u­lar­ly if they are in a high tax bracket.

Pri­or to 2018, loss­es due to theft could be deduct­ed as an item­ized deduc­tion, but the TCJA lim­it­ed the theft loss deduc­tion to loss­es attrib­ut­able to a fed­er­al­ly declared dis­as­ter until 2025. Since cryp­tocur­ren­cies have not been con­nect­ed to a fed­er­al­ly declared dis­as­ter, a tax­pay­er will not be able to claim a per­son­al theft loss.

There is a spe­cial excep­tion for vic­tims of Ponzi-type invest­ment schemes. In 2009, the IRS pub­lished Rev­enue Rul­ing 2009–9 to pro­vide tax relief to the vic­tims of Bernie Madoff’s $64 bil­lion Ponzi scheme. In this rul­ing, the IRS stat­ed that if any mon­ey put into an invest­ment account with the expec­ta­tion of prof­it and is found to be fraud­u­lent, any loss is con­sid­ered a busi­ness theft loss and not a per­son­al theft loss. There­fore, the per­son­al theft loss lim­i­ta­tion stat­ed above does not apply. Final­ly, if the loss­es exceed the taxpayer’s income for the year, they are con­sid­ered net oper­at­ing loss­es and either can be car­ried for­ward to off­set future income or car­ried back, which allows the tax­pay­er to claim a refund.

To claim this spe­cial theft loss, the tax­pay­er can claim the theft loss as they nor­mal­ly would, as long as they meet the require­ments of above rev­enue rul­ing. Alter­na­tive­ly, the tax­pay­er can use an option­al safe har­bor pro­ce­dure out­lined in Rev­enue Pro­ce­dure 2009–20, which was released con­cur­rent­ly with the rev­enue rul­ing. To meet the safe har­bor, the lead fig­ure in the invest­ment scheme must be charged (but not con­vict­ed) with crim­i­nal fraud, theft, or embez­zle­ment, and the tax­pay­er must claim the theft loss on the year the crim­i­nal charges are filed. The loss­es claimed are lim­it­ed to 95% of the loss­es if the tax­pay­er is not pur­su­ing third-par­ty recov­ery or 75% of the loss­es if they are pur­su­ing third-par­ty recov­ery. The loss amount is fur­ther deduct­ed by any amounts actu­al­ly recov­ered and rea­son­ably like­ly to be recov­ered in the future.

While the tax ben­e­fits can some­what ease the finan­cial pain of rug pull vic­tims, not every­one will be able to claim the theft loss. Because the loss is an item­ized deduc­tion, the tax­pay­er must first ensure that their total item­ized deduc­tions exceed the stan­dard deduc­tion for the year. For exam­ple, some­one who has no large med­ical expens­es, pays lit­tle state and local tax­es, has no mort­gage inter­est pay­ments, and does not give to char­i­ty is not like­ly to be able to claim the theft loss.

Assum­ing the tax­pay­er qual­i­fies for the item­ized deduc­tion, the next ques­tion is whether they suf­fered a deductible theft loss. Theft is clear if the per­pe­tra­tors are crim­i­nal­ly charged with fraud or embez­zle­ment, but was the tax­pay­er expect­ing a prof­it on their cryp­to or NFT trans­ac­tion? And what about NFTs or cryp­tocur­ren­cies that sim­ply did not achieve the mar­ket val­ue that the investor was expect­ing, even when the expect­ed val­ue was promised by the promoters? 

In Rev­enue Rul­ing 77–17, the IRS held that a theft loss deduc­tion can­not be tak­en on the worth­less­ness or dis­po­si­tion of stock, even if the decline was due to fraud­u­lent activ­i­ties of the corporation’s offi­cers and direc­tors, because they did not have the spe­cif­ic intent to deprive the share­hold­er of mon­ey and prop­er­ty. A theft loss could be denied for the loss in val­ue of a cryp­tocur­ren­cy or NFTs under sim­i­lar circumstances.

While the IRS’ theft loss guid­ance in 2009 applied main­ly to the Mad­off Ponzi scheme vic­tims, it hasn’t been with­drawn. If the tax­pay­er pur­chased an NFT or cryp­tocur­ren­cy with an expec­ta­tion of a prof­it in the future, they should be enti­tled to take the theft loss with­out the lim­i­ta­tions imposed by the TCJA.

This arti­cle does not nec­es­sar­i­ly reflect the opin­ion of The Bureau of Nation­al Affairs, Inc., the pub­lish­er of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Steven Chung is a tax attor­ney in Los Ange­les. He is also a week­ly colum­nist at the legal blog Above the Law, where he writes about tax­es, solo and small law firm prac­tice, and man­ag­ing stu­dent loans.

We’d love to hear your smart, orig­i­nal take: Write for Us

Source link

Please fol­low and like us:
Pin Share

Leave a Reply

Your email address will not be published.