It has been a roller coaster year for all markets, but none more so than the market for cryptocurrency and digital assets. You may have heard about a cryptocurrency exchange called FTX, which recently filed for bankruptcy, taking an estimated $32 billion of virtual currencies with it. FTX was the most recent and largest of several centralized crypto exchanges to collapse in 2022. The failure of these over-leveraged exchanges has contributed to the drastic decrease in cryptocurrency prices which have fallen more than 60% from their 2021 peak.
So, can investors who suffered losses claim those losses on their tax returns? Maybe. Maybe not. One of the interesting issues with crypto investments is how they’re treated from a tax standpoint. If you own Bitcoin or some other cryptocurrency, you would calculate gains and losses similar to how you would for stocks or ETFs: once you sell, the amount above or below what you paid for it is a gain or loss. Generally, losses on crypto investments are considered capital losses and can offset capital gains from other assets including stocks. In addition, if capital losses exceed capital gains a taxpayer can offset $3,000 in ordinary income ($1,500 for single filers), with the remaining excess loss carrying forward to offset future capital gains. Another nuance of digital asset taxation, according to IRS Notice 2014-21, the IRS currently classifies virtual currencies as a property and not a security, so wash sale rules would generally not apply in the case of a sale and repurchase.
Where it gets even more interesting is when you discover that somebody has hacked your account, or you lost the key to your cold storage wallet, threw away the hard drive that contained your wallet or otherwise no longer own these assets. In these unfortunate, but all-too-common cases, you can’t claim a loss on your tax return.
This may lead you to believe that FTX crypto losses would not be deductible, and the people who lost billions are out of luck. But that may not be the last word. Federal authorities plan to charge FTX founder Sam Bankman-Fried with, among other things, running a Ponzi scheme—that is, an arrangement where he kept investor money and paid out some of it to maintain the illusion that people were earning returns on their ‘investments.’ The IRS regulations specifically state that victims of a Ponzi scheme can claim their losses. It is expected that the IRS will issue guidance regarding whether FTX meets this definition, so it may be wise to delay filing if a taxpayer wanted to pursue this deduction.
The whole FTX mess is yet another red flag about the world of cryptocurrency investing, as if we needed additional ones. Whether you think of crypto as an investment or not the IRS expects the gains and losses to be reported on your tax forms.
Some of the above was provided by Bob Veres