Prosecution of cryptocurrency and NFT fraudsters may increase so victims can benefit from enhanced tax benefits

The phenomenal rise in Bitcoin’s value from 50 cents in 2011 to nearly $65,000 last November has resulted in the creation of many copycats. By 2022, it is believed that there are over 20,000 cryptocurrencies, although only about 11,000 of them are actively traded. Last year, the rise in popularity of non-fungible tokens (NFTs) also resulted in a similar explosion in value and number.

Despite the promises made by many crypto and NFT promoters, the truth is that most of them will fail and end up worthless. A few of them probably had legitimate uses and business plans that just didn’t work for one reason or another. But many of them were created with the intention of deceiving unsuspecting people.

These scams usually come in two forms. The first is known as the pig slaughter scam, where a scammer charms his victim with promises of quick riches to convince them to deposit money into a fake crypto account. The other is known as a rug pull, where fraudulent developers create a new crypto token or NFT project, pump up the price, and then extract as much value from them as possible before they disappear. Unlike the pig slaughter scam, which targets individuals, carpet pulling usually involves many victims because the organizers publicize their fraudulent project on chat groups and even on popular websites. These transactions have also been classified as Ponzi schemes since these scammers use other investors’ money to pay either initial investors or themselves.

These victims may be eligible for enhanced tax benefits. Last month, I wrote a column for Bloomberg in which I explained how investors who were victims of carpet pulling can claim a theft loss to reduce their taxable income. To summarize, victims of crypto or NFT fraud can claim an ordinary theft loss as an itemized deduction on their tax return and possibly use the losses to offset income in prior and future years. Normally, these losses are treated as capital losses which may not be useful to people who do not have capital gains to offset.

If victims can show that their cryptocurrency investments were actually Ponzi schemes, they can qualify for theft loss deductions using a safe harbor. To take advantage of this safe harbor, the principal figure in the investment scheme must be charged (but not convicted) in the United States of criminal fraud, theft or embezzlement, and the taxpayer must claim the theft loss in the year the criminal charges are filed. The claimed losses are limited to 95% of the losses if the taxpayer does not pursue third party coverage or 75% of the losses if they pursue third party coverage. The amount of the loss is deducted further with any amounts that have actually been recovered and with reasonable probability will be recovered in the future.

Considering that most crypto investors are young adults, and others may know little about cryptocurrencies and how they work, victims may feel more comfortable choosing the safe harbor. Doing so can also increase their chances of getting the most tax benefits possible. In that way, they will do everything they can to ensure that the main characters are charged with crime.

In the biggest crypto fraud cases, the main character(s) have been identified. For example, Do Kwon has been associated with the collapse of the cryptocurrency Luna and is wanted by South Korean prosecutors. The OneCoin cryptocurrency has been labeled a Ponzi scheme and its CEO has been charged with fraud in India.

The problem is that in most cases criminal charges are rare unless there are many victims or other compelling reasons to prosecute. The other problem is that sometimes the main character is not easily identified, so it can take years before they are charged with a crime.

However, even if there is no prosecution, victims of crypto and NFT scams can still take a theft loss if they invested the money with the intention of making a profit.

Victims of crypto and NFT scams may be able to get enhanced tax benefits. Although criminal charges against these fraudsters are rare, victims can put more pressure on prosecutors to investigate and charge the principals so they can take advantage of the IRS safe harbor, which simplifies the loss reporting process. This could lead to more arrests and prosecutions of fraudsters in the future.

Steven Chung is a tax attorney in Los Angeles, California. He helps people with basic tax planning and resolving tax disputes. He is also sympathetic to people with large student loans. He can be reached by email at [email protected]. Or you can connect with him on Twitter (@stevenchung) and connect him at LinkedIn.