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.
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. He can be reached through his website at stevenchung.biz.
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