Crypto Losses Are Not All Alike- Part 2

December 14, 2022

By  Murray Alter

There are still many facts that must be ascertained regarding the nature of the losses for FTX account holders and the causes that led to those losses. However, this article will now explore some additional potential remedies for taking deductible tax losses at some time in the future.

(See Crypto Losses Are Not All Alike for the first part of the examination of this subject.)

While “casualty and theft losses” of a personal nature are not currently deductible by individuals due to a moratorium on such losses that won’t end until after 2025, it may be possible to characterize such a loss as an “investment theft loss” under IRC Sec. 165(c)(2). This type of loss is not subject to the moratorium and results in an itemized deduction taken as an ordinary loss on Form 4684.

However, to qualify for this type of loss, the account had to have been established with an expectation of profit, there should be a “theft” under applicable state law, and there has to be a reasonable determination of the amount of the loss after considering the expectations of a recovery amount. It is unclear whether the facts at FTX have risen to this level of being able to ascertain with reasonable accuracy what a recovery might be, if any. In addition, it is unclear whether there was an actual theft or embezzlement of the account holder’s property or whether unsound business practices related to their business activities, with the related party, caused the bankruptcy. If the latter, the IRS does not view that as a theft loss. The Madoff case and Rev Procs 2009-09 and 2009-20 are useful in determining whether the FTX situation rises to the level of “investment theft loss.”

Finally, there is another avenue of approach to trigger loss recognition and that is the “abandonment” approach. The Code does not specifically mention abandonment losses but there are regs and numerous cases that have dealt with it and give us some guidance on how this works to create an ordinary loss (i.e., itemized deduction). The taxpayer would have to show an intent to abandon and some action that reflects that intent. In addition, there can be no consideration received by the taxpayer, not even the relief of liabilities, as that then creates a “sale or exchange” which while creating a loss, creates a “capital loss.”  Such losses are reported on Form 4797.

In the FTX context, it is uncertain how to communicate the intent to abandon and to whom. It may be that once a trustee in bankruptcy is established, the trustee becomes the proper recipient of proof of intent to abandon. If one is affected by the FTX debacle through a partnership that holds the account, it may be possible to inform the general partner of the partnership of one’s intent to abandon the partnership interest and trigger a loss. Naturally, the benefits of a loss in 2022 must be weighed against the prospects of some recovery. Also, if one holds tokens that have been impacted severely by the FTX bankruptcy, but no market exists on which to sell them, a transfer to a “null” account would serve to close the transaction so as to trigger the losses. Or some other method of “burning” the coin might trigger the loss but it is more likely a capital loss than an abandonment loss (to be determined based on facts and circumstances). Different wallets and different coins may have diverse ways of “burning” the coin and a careful review may lead one to either abandonment and ordinary loss treatment or capital loss treatment.

As tax returns are not due till the third quarter of 2023 with extensions, and as facts continue to come out daily, it may not be necessary to take action before year-end. Indeed, based on the accounts being frozen, it does not appear that any meaningful action can be taken other than the abandonment or burning route, if applicable. Please speak to your tax advisor before making any decisions.

Addendum: As new information continues to emerge as to why this bankruptcy happened, and as the IRS is likely staying attuned to both the evolving story and the demands for some relief from victims of this financial disaster, it is likely there will be IRS guidance at some point next year before extended due dates for filing. Meanwhile, Sam Bankman Fried had claimed too many demands on his time to personally appear before Congress, as he promised, and was ultimately recently arrested in the Bahamas. Read into this what you will.  Also, the CEO of Alameda, Caroline Ellison, has hired two attorneys from WilmerHale who have deep experience on the government’s side in recent SEC enforcement cases regarding crypto security offerings and also have some experience in the Madoff case. Once again, read between the lines. There is almost daily news that hints at further serious developments to come.

About Murray Alter

Murray Alter is a Tax Partner specializing in investment partnerships, venture capital funds, hedge funds, distressed debt funds, funds of funds, and the ancillary entities associated with these types of investments.