If you were ripped off, would a tax write-off make you feel just a little better? In recent years, scammers have flooded out of the gates to try to part unsuspecting investors with their Bitcoin. Let's discuss U.S. tax rules.
Was your Bitcoin stolen? Potential Tax Benefits for your Loss! (Crypto Tax Blog Part I-A) Appendix D
General
Below are a few of the common ways to lose Bitcoin (even Altcoin or fiat) to theft/fraud.
- A computer hacker obtains access to a person’s cryptocurrency wallet, and withdraws the funds from the hacked wallet.
- A person invests in an Initial Coin Offering (ICO) which turns out to be fraudulent (i.e. worthless tokens).
- A person invests in a Crypto Ponzi scheme, such as fraudulent investment in a high yield product.
Investopedia provides a concise definition of “Ponzi Scheme”:
“A Ponzi scheme is a fraudulent investing scam promising high rates of return with little risk to investors. The Ponzi scheme generates returns for older investors by acquiring new investors. This is similar to a pyramid scheme in that both are based on using new investors' funds to pay the earlier backers. For both Ponzi schemes and pyramid schemes, eventually there isn't enough money to go around, and the schemes unravel.” [Ponzi Scheme, http://www.investopedia.com/terms/p/ponzischeme.asp#ixzz4tn4ubkJL]
U.S. Tax Impact
As discussed in the previous Crypto Tax Blogs (and Notice 2014-21), the IRS treats Bitcoin and other “convertible virtual currencies” (i.e. Certain Altcoins that is tradeable for USD/BTC/Altcoins) as property, therefore general principles of property taxation apply to Bitcoin. The discussion below is for individuals who are investing directly in investment arrangements (not through a partnership/trust, etc.)
Losses of money/property related to Theft is generally deductible under U.S. income tax code, subject to various complex rules/limits. Below are general starting points to figuring out the loss:
Step #1 - Theft or Capital Loss
Generally, for U.S. income tax, a loss from the three schemes above could be a “theft loss” or a “capital loss”, depending on the circumstances.
For US tax purposes, “theft” generally means criminal appropriation of another’s property, including loss from swindling, false pretenses and guile (Revenue Ruling 2009-09). Generally, whether a theft occurred for tax purposes would be based on laws in the jurisdiction where the theft occurred and, and it occurred with criminal intent. A conviction is not required to determine a theft occurred (Revenue Ruling 2009-09).
A capital gain/loss is the loss on the disposition of a capital asset. A disposition/worthlessness of stock tradeable on the open market is a capital loss (not a theft loss), even it relates to fraudulent activities of the board of directors/officers (Revenue Ruling 2009-09, Revenue Ruling 77-17). A U.S. person’s loss from capital assets (after netting against gains) is limited to $3,000 per year (see section 1211 and 1212).
Step #2– Is the Loss from Profit Activity or Unrelated Activity (if Theft)?
There are two general types of theft (non-capital) losses which are deductible as itemized deductions:
(a) Profit Activity - Losses incurred in a transaction entered into for profit (section 165(c)(2))
(b) Unrelated Activity- Losses not connected to a transaction entered into for profit (section 165(c)(3))
A theft loss from a Profit Activity is not subject to certain loss limitations (below) under Section 165(H).
The theft loss from an Unrelated Activity is limited due to a set of “floors”:
(a) The first $100 of loss is not deductible and
(b) The remaining loss is only deductible to the extent it exceeds 10% of the person’s adjusted gross income. For someone with a $25,000 in gross income, and a $5,000 Unrelated Theft loss, they would be able to deduct $2,400 ($5,000 loss, less $100 = $4,900; and 10% of $25,000 Gross Income is $2,500, meaning $4,900-$2,500 = $2,400 allowable loss).
As of RR 2009-09, both types of Theft losses are not subject to general itemized limitation rules (i.e. 2% floor rule).
Step #3 – Timing and Amount of Loss Deduction
Capital Loss
A capital loss (non-theft) deductions is limited to $3,000 per year (after net against other capital gains); as discussed above. The disposition of the capital asset (or worthlessness/abandonment) triggers the initial loss year.
Theft Loss
A theft loss is generally allowed in the year the theft occurs, unless there is a reasonable possibility of recovering the loss. Generally, the amount of the theft loss is the basis in the property stolen (or money), less any reimbursement/compensation received or anticipated.
Generally, for an investment theft, the amount of money/property that is contributed into the investment, less withdrawals and other recoveries, is the amount of the deductible theft loss. However, amounts that are previously reported by the scammer to the investor as income, then reported on the investor’s tax return properly, and then reinvested in the program, increases the amount of the theft loss deduction.
For example, a person invests $1,000 into a scam investment in year 1, is credited with fake “profits” in year 1 and 2 totaling $250 (which are reported as income for tax purposes & reinvested), and the scammer takes off with the outstanding money in year 3. The investor also took a withdrawal in year 2 of $50, and received $100 from the insurance company in year 3 due to filing a theft claim.
In this example, the theft loss is deductible in year 3. The amount of the loss is calculated as:
$1,000 invested + $250 reported income - $50 withdrawal - $100 insurance = $1,100 Theft Loss
A tax advisor should be contacted, especially if there is a possibly of recovering a portion of the loss in future years, as the prior year returns may need to be amended, or a correction could be necessary in a future return, in order to correct the amount of the theft loss to the final amount.
Step #4 - Do You Even Itemize, Bro?
The Theft loss deduction is an itemized deduction. For a person that does not itemize deductions, there may be no tax benefit of the loss.
Typical itemized deductions are state income tax, real estate & car tax, mortgage interest, significant unreimbursed health expenses, and charitable donations. In 2017, it is estimated a single person would opt to itemize if their total deductions (including theft loss) exceeds the standard deduction of $6,350; the amount is $12,700 if a married couple is filing jointly (MFJ). If the total itemized deductions (including theft loss) are less than the standard deduction, the person will usually take the standard deduction instead and thus will not benefit from a theft loss.
If Trump’s proposed tax reform is passed, this all might change. Also, if a person is in Alternative Minimum Tax (AMT), it gets even more complicated. A tax advisor should be contacted to help figure out the true benefit of a significant theft loss.
Safe Harbor for Ponzi Schemes
Even though easy in an academic setting, figuring out the nature, amount, and timing of being defrauded for tax purposes is complex. Therefore, the IRS created as “safe harbor” rule for certain Ponzi Schemes in Revenue Procedure 2009-20. The safe harbors allows a 95% deduction for losses where the taxpayer is not seeking to recover lost funds, or a 75% deduction if the taxpayer is seeking to recover lost funds. The safe harbor is specific to Ponzi Schemes for which the US Federal/State government has either convicted or filed a complaint with regard to a fraud. A tax advisor should be contacted.
Hacked Wallet
For a hacked wallet, this would likely be treated as a theft loss as the BTC was literally stolen.
If the wallet was holding an investment in Bitcoin for purposes of generating profit, then the theft loss could be treated as a Profit Activity thus not subject to the $100/10% floors. However, if the wallet was primarily used for personal transactions unrelated to investing (i.e. purchases from Microsoft Store or Overstock, etc.), the IRS may treat this as an Unrelated Loss, subject to the $100/10% floors (explained above). A tax advisor should be consulted.
Initial Coin Offering
Unfortunately, worthless ICO tokens may be treated as capital losses (not theft losses), even more so if SEC has the intent to classify some of these tokens as securities. In a bitcoin for token exchange, the bitcoin was willingly given up by an investor; as opposed to literal theft due to hacking/Ponzi. A tax advisor should be consulted.
Ponzi Scheme
In Revenue Ruling 2009-09, a person opened an investment account with a supposed investment advisor/broker, and it turned out to be a Ponzi scheme. This transaction was treated as entered into for profit and thus not subject to the $100/10% floor limitation (explained above). A Ponzi scheme loss related to crypto products would seem to be a theft Loss from a Profit Activity, not subject to the $100/10% floors, if the facts are similar to Revenue Ruling 2009-09. A tax advisor should be consulted.
Takeaway
I hope this article provides some silver lining for those who have been devastated by theft/fraud in cryptocurrency transactions. If you are a U.S. person who lost a significant amount of money/BTC, it may be worth your time to contact a tax advisor.
Disclaimer: This series contains general discussion of U.S. taxes in a developing and unclear area of tax law. As always, you should consult your own tax advisor in your jurisdiction to determine your specific situation as this is not personal advice; and consider any future guidance by the Congress/IRS after the date of this article. Under Circular 230 to the extent it applies, this article cannot be used or relied on to avoid any tax or penalties in the U.S., its States or any other jurisdictions.
Link to Rulings/Procedures
https://www.irs.gov/newsroom/ponzi-scheme-questions-and-answers
Picture Credits
https://pixabay.com/en/users/3dman_eu-1553824/
https://pixabay.com/en/users/succo-96729/
https://pixabay.com/en/users/mohamed1982eg-5229782/