Crypto Bankruptcies Leave Taxpayers in Limbo in Filing Season

Investors who lost money on now-bankrupt crypto exchanges are stuck in limbo this filing season, tax practitioners say, unable to claim losses on digital assets with little recourse for obtaining relief.

Several cryptocurrency firms filed for bankruptcy last year—including FTX, once one of the world’s largest. That has left many investors with assets frozen in bankruptcy proceedings. Outside the courts, the IRS has eliminated the option for taxpayers to claim losses under tax code Section 165 if they’ve experienced a steep decline in value.

Tax professionals say investors’ best bet is to keep thorough records and wait for more information from the courts or more guidance from the IRS to determine the next step toward relief.

“It makes sense right now to kind of take a wait-and-see approach,” said David Kemmerer, co-founder and CEO of crypto tax software firm CoinLedger.

“It’s kind of not the answer people want to hear,” he continued, “but if you have a claim to assets that are now kind of being wrapped into a bankruptcy process, it’s not definitive how much—if any, at all—you’re going to receive back.”

A Crypto Winter

Over the course of roughly six months in 2022 several cryptocurrency firms went bankrupt, starting with Voyager Digital in July. November capped out the year with the fall of FTX and its crypto empire.

About a month later, Bankman-Fried was arrested in the Bahamas on eight criminal counts, including conspiracy to commit wire fraud. Prosecutors allege Bankman-Fried misused billions of dollars of customers’ funds before the FTX collapse.

Separately, the Securities and Exchange Commission and Commodity Futures Trading Commission sued the former CEO over his involvement in the FTX collapse.

Investors Stuck in the Middle

Investors—both those whose crypto is stuck with now-bankrupt firms and those who’ve watched the value of their tokens drastically dwindle—are anxious for answers about if, when, and how they can mitigate the financial damage as this year’s tax filing deadline approaches.

Lorenz Haselberger, partner at Shearman & Sterling LLP, said the question that keeps coming up is, what to do in the case that a “crypto asset goes from $1 per token to a cent per token, or, it’s stuck in a cryptocurrency exchange that is no longer allowing redemptions.”

Investors do have the option to sell their tokens that have declined in value and harvest a loss, barring limitations with respect to those losses. However, for those who hold on to their coins, the federal government indicated that a steep decline in value does not constitute a loss under Section 165.

In January, the IRS released guidance stating that even if a taxpayer with cryptocurrency investments has sustained a “substantial decline in value,” the taxpayer has not suffered a loss under Section 165 because it “still has value.” The IRS added that even if a taxpayer had sustained a loss under Section 165, itemized deductions are disallowed through 2025 because of Section 67 (g) enacted by the 2017 tax law.

After FTX collapsed, currencies associated with it—such as FTT, Serum, and Solana—plummeted. FTT, the native coin of FTX, went from trading at $25 on Nov. 5 to around $3.50 on Nov. 11 and has yet to recover, according to Coincap. Even Bitcoin was hit, falling from over $21,000 on Nov. 5 to just over $17,000 on Nov. 11. It is currently trading at around $24,100.

Coins may retain some value even tied up on a defunct exchange, but the result for many clients has been big declines in value and an inability to access their crypto.

“Unfortunately, volatility is not enough for purposes of taking tax deductions,” said Sahel A. Assar, International Tax Counsel and Chair of Buchanan Ingersoll and Rooney’s Blockchain and Digital Assets Practice Group. “To take the deduction, the taxpayer must abandon or otherwise dispose of the digital asset as evidenced by a clear and completed transaction that is fixed by an identifiable event sustained during the tax year. Holding cryptos that have lost or diminished value isn’t sufficient for this purpose.”

Compounding the issue for taxpayers is that assets are frozen until bankruptcy proceedings are resolved—a process that may take years to play out.

“There seems to be a lot of interest by disgruntled crypto users in filing a lawsuit,” Assar said. “However, it’s the larger crypto exchanges, such as Genesis or FTX, where bankruptcies are at play in a measured way, and until they actually file and bring the filings to closure, you can’t just willy-nilly take a Section 165 deduction because your value has diminished.”

Speaking at the American Bar Association Midyear Tax Meeting in San Diego, Christopher Wrobel, special counsel to the associate chief counsel at the IRS, indicated the agency would consider loss claims that have facts similar to those in the January guidance.

Solutions

Even amid the uncertainty, there are some circumstances in which taxpayers will be able to find reprieve.

There is talk in the tax community that FTX investors will be able to deduct losses based off the guidance the IRS issued following the Bernie Madoff scandal. Madoff pleaded guilty in 2009 to 11 criminal charges related to a massive Ponzi scheme.

Around the time of his conviction, the IRS issued Rev. Rule 2009-9 and Rev. Proc. 2009-20, describing how those affected by the Ponzi scheme may be able to claim losses that resulted from criminal fraud—something that hasn’t yet been proved in the FTX debacle. Bankman-Fried has maintained his innocence, pleading not guilty in expectation that he will face trial in October.

Assar cautioned that when it comes to claiming this kind of loss for Bankman-Fried’s oversight of FTX, “we’re not there yet.”

At the midyear tax meeting, however, Wrobel said IRS is considering guidance similar to what it issued in 2009.

In the case of Celsius, investors may be able to claim a nonbusiness bad debt this year, said Jordan Bass, owner at Taxing Cryptocurrency.

In early January, US Bankruptcy Judge Martin Glenn determined Celsius owns the coins customers placed in interest-bearing “Earn Accounts,” citing the company’s terms of use. Bass explained the bankruptcy court effectively determined the assets deposited in the Earn Accounts were debts of Celsius.

“Those deposits into the Celsius Earn Account would have been effectively a taxable sale for the Celsius debt,” Bass said.

“But the best way to observe it from a loss perspective is that now that debt is worthless,” he continued. “Celsius customers, those users, may be able—may be able—to have this bad debt deduction, this write-off on their return.”

However, Bass stressed that a multitude of factors determines whether or not a client can claim a nonbusiness bad debt, and, if possible, the crypto customer should wait for more guidance from the IRS to claim a loss.

“Getting more information is always, always, always going to be the most beneficial approach,” he said.

For now, many crypto customers will have to sit tight and see how these issues play out in the coming years

“My recommendation is keep good records of how much you invested,” said Shehan Chandrasekera, head of tax strategy at CoinTracker, “especially in the cost basis of the assets that you had in the exchange—meaning how much you pay for those assets.”