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Virtual Currency Losses and the FTX Collapse

With most virtual currencies prices down significantly year-to-date, and the collapse of large companies in the industry such as FTX, taxpayers may be wondering how to deduct the losses on their tax returns.

The simplest case is where investors dispose of their virtual currency by selling on an exchange. The character of the gain or less realized on the disposition of virtual currency depends on if it is a capital asset owned by the taxpayer. The IRS defines a capital asset as everything a taxpayer owns and uses for personal purposes, pleasure, or investment. Most investors understand that a disposition of a capital asset will result in the taxpayer realizing a capital gain or loss on the transaction.

But what if an investor did not dispose of their holdings in a planned sale, but instead the investment becomes illiquid due to a currency’s or firm’s collapse? As of the date of this post, there is still a market for FTT (FTX’s token), but it is unclear whether the assets on the FTX exchange are worthless, or illiquid with the possibility of partial recovery in the future.

If FTX declares or is forced into bankruptcy, investor losses will likely not be recognizable until the bankruptcy proceedings are complete.

Worthless security? While the IRS does allow a deduction for worthless securities, the SEC has not yet declared that cryptocurrencies are securities. Cryptocurrencies are a type of virtual currency with the terms often being used interchangeably. If virtual currencies are declared securities, a taxpayer could also consider an abandonment loss. To abandon a security, one must permanently surrender and relinquish all rights in the security and receive no consideration in exchange for it.

Ponzi scheme? The founder of BitConnect, a cryptocurrency, was indicted earlier this year in a $2.4 billion Ponzi scheme. It’s not yet clear whether the FTX collapse meets the definition of a Ponzi scheme. However, if it does, taxpayers may deduct their losses as a theft loss instead of a capital loss. While a capital loss can only offset ordinary income up to $3,000 per year, theft losses do not face that limit.

Nonbusiness bad debt? Investors would need to prove they were loaning money to the company. On top of that, they would need to prove their entire investment has become worthless. Celsius, a large bankrupt cryptocurrency lending platform, is a company that outlined in their terms and conditions that any digital asset transferred to their platform constitutes a loan from the user to Celsius. This is a different model from FTX.

Ultimately, taxpayers should not expect immediate relief from the IRS regarding assets currently locked on these platforms and exchanges, but with high profile failures such as FTX, we hope the IRS will soon move to clarify the foregoing issues.

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