Victims of crypto and NFT fraud can claim theft loss deductions
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 became known. Promoters of NFTs argued that their uniqueness would make them collectible, creating demand that would lead to a profit if they were later sold.
Despite the potential and promise, many cryptocurrencies and NFTs have gone bust in recent months, with hordes of investors losing most, if not all, of their value. In some cases, the creators and promoters were simply unable to achieve the goals they promised. But others were scams where the creators had no intention of paying back their investors and would disappear after taking the investors’ money, also known as rug pulls.
While most victims of crypto and NFT scams will not recover their investments, they may be able to take advantage of the tax benefits of their losses. The most advantageous is the theft loss deduction, which can be used to offset ordinary income, although the Tax Cuts and Jobs Act has limited its use to personal losses.
The IRS’s definitive guidance regarding the US tax treatment of cryptocurrency is in Notice 2014-21. It states that such currency is generally treated as property, so the price paid for the cryptocurrency becomes the cost basis. If it is later sold, there is a gain or loss on the transaction. This note is likely to apply to NFT transactions as well. Unfortunately, some taxpayers will not be happy to take a capital loss as they may not have capital gains to offset the losses. They may also prefer to deduct the loss from their ordinary income, especially 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 linked 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 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 is deposited 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 loss limitation for personal theft stated above does not apply. Finally, if the losses exceed the taxpayer’s income for the year, they are considered net operating losses and can either be carried forward to offset future income or carried back, allowing the taxpayer to claim a refund.
To claim this special theft loss, the taxpayer can claim the theft loss as normal, as long as they meet the requirements in the income determination above. Alternatively, the taxpayer can use an optional safe harbor procedure outlined in Revenue Procedure 2009-20, which was issued at the same time as the revenue ruling. To meet the safe harbor, the principal in the investment scheme must be charged (but not convicted) of criminal fraud, theft or embezzlement, and the taxpayer must claim the theft loss in the year the criminal charges are brought. 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.
Although the tax benefits may ease the financial pain of victims of theft, 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 does not have large medical expenses, pays little state and local taxes, has no mortgage interest and does not give to charity is unlikely 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 charged with fraud or embezzlement, but did the taxpayer expect a profit on the crypto or NFT transaction? And what about NFTs or cryptocurrencies that simply did not achieve the market value that the investor expected, 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 the fraudulent activities of the company’s officers and directors, because they did not have that specific intent. to deprive the shareholder of money and property. A theft loss can be denied for the loss in value of a cryptocurrency or NFTs in similar circumstances.
While the IRS’s 2009 theft loss guidance primarily applied to victims of the Madoff Ponzi scheme, it has not been withdrawn. If the taxpayer purchased an NFT or cryptocurrency with an expectation of 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.
Author information
Steven Chung is a tax attorney in Los Angeles. He is also a weekly columnist for the legal blog Above the Law, where he writes about taxes, solo and small law practice, and student loan administration.
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