In 2017, when the price of one Bitcoin shot up to $20,000 almost overnight, it was all over the news. After a few years, the NFTs also become well-known. The people who sold NFTs said that because they were one-of-a-kind, they would become collectibles, which would increase demand and lead to a profit if they were sold later.
Even though they had potential and promises, many cryptocurrencies and NFTs have gone bankrupt in the past few months, causing investors to lose most or all of their money. In some cases, the people who made or promoted the idea just couldn’t reach the goals they said they would. But others were scams where the people who made them didn’t plan to pay back their investors and disappeared after taking their money. These scams are called “rug pulls.”
Most people who lose money because of crypto and NFT fraud won’t get it back, but they may be able to get tax breaks because of it. The theft loss deduction is the most helpful. It can be used to offset regular income, but the Tax Cuts and Jobs Act limits how it can be used for personal losses.
Notice 2014-21 from the IRS gives the final word on how cryptocurrencies are taxed in the US. It says that in general, this kind of currency is treated like property, so the price paid for the cryptocurrency becomes the cost basis. If it is sold later, there is either a capital gain or a capital loss. This notice could also be used for NFT transactions. Some taxpayers may not like taking a capital loss because they may not have enough capital gains to make up for it. They might also choose to subtract the loss from their regular income, especially if they are in a high tax bracket.
Before 2018, theft losses could be deducted as an itemized deduction. However, the TCJA only lets theft losses be deducted until 2025 if they are caused by a federally declared disaster. Since there hasn’t been a federally declared disaster related to cryptocurrencies, a taxpayer won’t be able to claim a personal theft loss.
For those who fell victim to Ponzi-style financial fraud, there is an unique exception. To provide tax relief to the victims of Bernie Madoff’s $64 billion Ponzi fraud, the IRS released Revenue Ruling 2009-9 in 2009.According to this judgement from the IRS, any loss resulting from the unauthorized use of funds placed in an investment account is treated as a corporate theft loss rather than a personal theft loss. Therefore, the above-mentioned personal stolen loss limitation is not applicable. Last but not least, if the losses exceed the taxpayer’s annual income, they are deemed net operating losses and can either be carried forward to reduce future income or carried back to enable the taxpayer to receive a refund.
As long as they comply with the terms of the aforementioned revenue rule, the taxpayer may deduct the theft loss as they normally would in order to claim this unique theft loss. As an alternative, the taxpayer may follow the voluntary safe harbor process described in Revenue Procedure 2009-20, which was published simultaneously with the revenue ruling. To qualify for the safe harbor, the main participant in the investment plan must be accused of criminal fraud, theft, or embezzlement (but not found guilty), and the taxpayer must deduct the theft loss in the year the criminal charges are brought. If the taxpayer is not pursuing third-party recovery, the damages claimed are restricted to 95% of the losses, or to 75% of the losses if they are. Any sums that were actually recovered or that are reasonably likely to be recovered in the future are further subtracted from the loss amount.
Although the tax advantages can help rug pull victims in some ways, not everyone will be able to claim the theft loss. The taxpayer must first make sure that their total itemized deductions for the years are greater than the standard deducation because the loss is an itemized deduction.
For example, someone who has no large medical expenses, pays little state and local taxes, has no mortagage interest payments, and does not give to charity is not likely to be able to claim the theft loss.
Assuming that the taxpayer is eligible for the itemized deduction, the next question is whether or not they had a theft loss that could be deducted. Theft is clear if the thieves are charged with fraud or embezzlement, but did the taxpayer expect to make money on their crypto or NFT transaction? And what about NFTs or cryptocurrencies that didn’t reach the market value the investor was hoping for, even though the promoters said they would?
In Revenue Ruling 77-17, the IRS said that a theft loss deduction cannot be taken on the worthlessness or sale of stock, even if the stock’s value went down because of fraudulent actions by the corporation’s officers and directors. This is because the officers and directors did not set out to steal money and property from the shareholder. In similar situations, a theft loss could be denied if the value of a cryptocurrency or NFTs went down
Even though the IRS’s 2009 theft loss guidance mostly helped victims of the Madoff Ponzi scheme, it hasn’t been taken away. If the taxpayer bought an NFT or cryptocurrency with the hope of making money in the future, they should be able to take the theft loss without having to worry about the TCJA’s restrictions.