Crypto bankruptcies leave taxpayers in limbo during 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 chance of 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 of the courts, the IRS has eliminated the ability for taxpayers to claim losses under Internal Revenue Code Section 165 if they have experienced a sharp decline in value.

Tax experts say investors’ best option 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 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 claims on assets that are now kind of wrapped up in a bankruptcy proceeding, it’s not definitive how much — if any — you going to get back.”

A crypto winter

In the space of about six months in 2022, several cryptocurrency firms went bankrupt, starting with Voyager Digital in July. November ended 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 fraud. Prosecutors allege that Bankman-Fried misappropriated billions of dollars of client funds before the FTX collapse.

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

Investors are stuck in the middle

Investors — both those whose crypto is stuck with now-bankrupt firms and those who have seen the value of their tokens plummet — are eager for answers on if, when and how to 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 event that a “crypto-asset goes from $1 per token to one cent per token, or, it’s stuck in a cryptocurrency exchange that no longer allows redemptions.”

Investors have the option to sell their tokens that have fallen in value and reap a loss, subject to limitations with respect to those losses. However, for those holding on to their coins, the federal government indicated that a sharp decline in value does not constitute a Section 165 loss.

In January, the IRS issued guidance stating that even if a taxpayer with cryptocurrency investments has had a “significant decline in value,” the taxpayer has not suffered a section 165 loss because it “still has value.” The IRS added that even if a taxpayer had incurred 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, the currencies associated with it – such as FTT, Serum and Solana – fell. FTT, the original coin of FTX, went from trading at $25 on November 5th to around $3.50 on November 11th and has yet to recover, according to Coincap. Even Bitcoin was hit, falling from over $21,000 on November 5th to just over $17,000 on November 11th. It is currently trading at around $24,100.

Coins can retain some value even linked to a closed exchange, but the result for many customers has been large drops in value and the inability to access crypto.

“Unfortunately, volatility is not enough to take a tax deduction,” 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 as determined by an identifiable event occurring during the tax year. Holding cryptos that have lost or reduced value is not sufficient for this purpose.”

Complicating the issue for taxpayers is that assets are frozen until the bankruptcy proceedings are resolved – a process that can take years to play out.

“There seems to be a lot of interest from disgruntled crypto users to file a lawsuit,” Assar said. “But it’s the larger crypto exchanges, like Genesis or FTX, where bankruptcies are in play in a measured way, and until they actually file and bring the filings to a close, you can’t just intentionally take a Section 165 deduction because your value has became smaller.”

Speaking at the American Bar Association Midyear Tax Meeting in San Diego, Christopher Wrobel, special counsel to the assistant general counsel at the IRS, indicated that 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 where taxpayers will be able to find reprieve.

There is talk in the tax community that FTX investors will be able to deduct losses based on the guidance issued by the IRS after 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 Fox. Rule 2009-9 and Fox. Proc. 2009-20, which describes how those affected by the Ponzi scheme may be able to claim losses resulting from criminal fraud – something that has yet to be proven in the FTX debacle. Bankman-Fried has maintained his innocence, pleading not guilty in anticipation that he will face court 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 the IRS is considering guidance similar to what it issued in 2009.

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

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

“These deposits into the Celsius Earn account would effectively have been 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, these users, might be able — might be able — to get this bad debt deduction, this write-off when they come back.”

However, Bass emphasized that a number of factors determine whether or not a client can claim a non-business bad debt, and if possible, the crypto client should wait for more guidance from the IRS to claim a loss.

“Getting more information will always, always, always 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 to keep a good record of how much you invested,” said Shehan Chandrasekera, head of tax strategy at CoinTracker, “especially in the cost basis of the assets you had in the exchange – that is, how much you are paying for those assets.”