The Wild West of Investing: Consider Tax Implications of Cryptocurrency Losses

The cryptocurrency world is evolving quickly, and like many hopeful investors, I have taken the plunge. For the uninitiated, cryptocurrency is considered “the money of the future” because it’s digital, global, and unregulated for now.  And, while crypto can be used to buy products and services, trading cryptocurrency for profit is what motivates and excites investors.  

Like most small investors, I regularly check my Crypto Account Wallet balance hoping for immediate wealth.  When recently denied access to my account, I worried the funds were lost or stolen and quickly contemplated my options.  Fortunately, my investment was intact.

But what if I was not so lucky or had been conned? What recourse did I have, and what were the ramifications of such loss? Unfortunately, hacked wallets, Initial Coin Offerings (ICO’s) fraud, incorrect web addresses, and stolen coins/tokens are commonplace in digital investing.

Investing in Cryptocurrency

Since its inception, cryptocurrency has been a high-risk, high reward investment due to unpredictable price volatility. Cryptocurrency is treated as property according to IRS Notice 2014-21, and thus the general tax principles applicable to property transactions apply to transactions utilizing virtual currency. Therefore, from a tax perspective, there are three types of “losses” for individual taxpayers resulting from cryptocurrency: casualty loss, theft loss, or investment capital loss.

Casualty Loss:

According to IRC Section 165(c)(3), casualty losses are lost or destroyed property occurring from sudden, unexpected, or unusual events. Casualty losses are associated with hurricanes, tornadoes, fires, or other natural disasters. The intricate casualty loss rules have various thresholds to claim a deduction on Form 4684, Casualties and Thefts. However, since-2017, deductions for casualty losses were only attributable to a Federally declared disaster. As a result, any crypto losses defined as “casualty loss” would not be deductible for tax purposes. Casualty losses from crypto can include but are not limited to lost coins sent to an incorrect address or coins lost due to access denial to wallets and exchanges.

Theft Loss:

Under IRC Section 165(a) and 165(e), the general rule for losses is that a deduction is allowed if sustained during the loss and not compensated by insurance or otherwise. The taxable year of the theft loss would be treated during the taxable year of discovery. Unlike a casualty loss occurring from an unusual or not ordinarily anticipated event, “theft losses” are more akin to illicit acts barred under state law with criminal maliciousness.

In Revenue Ruling 2009-09, “theft loss” defined a “theft” for federal income tax purposes includes any criminal appropriation of another’s property for the use of the taker, including theft by swindling, false pretenses, and any other form of guile. Theft losses with cryptocurrency could include hacked wallets or exchanges and stolen tokens/coins. Like casualty losses, post-2017 taxable year, “theft losses” could only be deducted with a federal declared disaster ultimately, resulting in a nondeductible tax result for the taxpayer. As always, keeping passwords private and unique, especially with digital investments, can help prevent potential fraud or loss.

Investment Loss:

While theft and casualty losses are not favorable for taxpayers, there is potential investment capital loss. Parallel to stock losses as defined by IRC Section 1211(b), “losses from sales or exchanges of capital assets shall be allowed only to the extension of the gains from such sales or exchanges” for individual taxpayers; limited to $3,000 per taxpayer ($1,500 if married filing separately.) While IRS guidance regarding cryptocurrency is scarce, “investment losses” could be from exchange shutdowns or an Initial coin offering (ICO) token. We expect further IRS clarification, but the loss would likely be limited.

Be Prepared

Investors interested in exploring the “wild west” of cryptocurrency investing should carefully evaluate its advantages and disadvantages and prepare for instability. Recent articles describing billion-dollar losses in scams and thefts on decentralized finance platforms (“DeFi”) remind us that unregulated financial transactions can be equally risky and lucrative.

Unless Congress passes new legislation or taxpayers have the potential to claim losses that arose before January 1, 2018, the current tax rules on lost or stolen cryptocurrency do not appear favorable to individual taxpayers. As with all investments, know your risk tolerance and talk with your tax advisor to fully understand potential unintended tax consequences before investing.

Adam Korenfield, CPA
Expert
Tax Director

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