There are still many unresolved questions regarding the nature of FTX account holders’ losses and the causes that led to them. While the complete picture continues to emerge, this article explores additional strategies for potentially claiming deductible crypto tax losses in the future.
Understanding Investment Theft Losses Under IRS Rules
Currently, “casualty and theft losses” of a personal nature are not deductible due to a moratorium that remains in effect until after 2025. However, crypto investors may be able to categorize FTX-related losses as “investment theft losses” under IRC Section 165(c)(2) — a critical distinction.
An investment theft loss:
- It is not subject to the current moratorium, and
- Allows an ordinary loss deduction claimed on Form 4684.
To qualify:
- The account must have been created with the expectation of making a profit.
- There must be a valid theft under state law.
- A reasonable estimation of losses must be possible, factoring in any expected recovery.
It remains unclear whether the FTX facts meet these standards. Specifically, whether:
- Actual theft or embezzlement occurred, or
- The downfall resulted from unsound business practices and related-party transactions (the IRS generally does not consider poor management a theft loss).
For guidance, taxpayers can look to the Madoff case and Revenue Procedures 2009-09 and 2009-20 as precedents when evaluating whether FTX-related losses rise to the level of an investment theft loss.
Exploring Loss Recognition Through Abandonment
Another potential tax strategy is claiming an abandonment loss. While the Internal Revenue Code does not explicitly reference abandonment losses, tax regulations, and case law provide a framework for doing so.
To qualify for abandonment loss treatment:
- The taxpayer must demonstrate a clear intent to abandon the property and
- Take affirmative action reflecting that intent.
Importantly, no consideration (even relief from liabilities) can be received. Otherwise, the event is treated as a sale or exchange, resulting in a capital loss — not an ordinary loss. Abandonment losses are generally reported on Form 4797.
In the FTX context:
- It remains uncertain how best to communicate abandonment intent and to whom.
- Once a bankruptcy trustee is appointed, they may be the appropriate party to notify.
- If losses are held through a partnership, communicating abandonment to the general partner may trigger loss recognition.
Investors must also weigh the immediate benefit of claiming a 2022 loss against the potential for future recoveries.
Crypto Token Losses and “Burning” Assets
For FTX-affected tokens with no available market, transferring assets to a “null” wallet or using token-burning mechanisms could trigger a recognized loss. However:
- These scenarios typically create a capital loss rather than an abandonment loss.
- Outcomes depend heavily on the specific facts and circumstances of the asset and platform involved.
Different wallets and blockchains may have varied processes for burning or abandoning tokens, requiring careful review to determine optimal tax treatment.
Timing, IRS Guidance, and Emerging Developments
Given that extended tax returns are not due until late 2023, and with new facts unfolding daily, immediate action may not be necessary for most taxpayers. That said, it is advisable to:
- Consult closely with a qualified tax advisor and
- Monitor developments closely, especially regarding possible IRS guidance expected before final filing deadlines.
Notably:
- Sam Bankman-Fried was recently arrested in the Bahamas after declining to testify before Congress.
- Caroline Ellison, CEO of Alameda Research, has retained attorneys with strong backgrounds in SEC crypto enforcement and prior involvement in the Madoff case.
These events signal that serious legal and regulatory developments are likely ahead — all of which could impact the ultimate tax treatment of FTX-related losses.
2 Characterising elements of crypto-assets
Crypto assets can be examined through multiple lenses: their underlying technology, distinctive features, and the broader economic impact they may create. While cryptography is central to the concept—hence the term “crypto-asset”—it is essential to recognize that traditional assets, such as money and financial instruments, can also be recorded using cryptographic systems, mainly through distributed ledger technology (DLT). However, the use of DLT does not inherently differentiate crypto-assets from other forms of digital assets. Issuers of digital assets are generally free to switch the technology used for recording without changing the nature of the asset itself. As a result, defining crypto-assets based solely on the technology employed would undermine the consistency of data analysis over time and limit its informational value.
To ensure consistency across time and technological developments, the European Central Bank (ECB) defines crypto-assets as “a new type of asset recorded in digital form and enabled by the use of cryptography that is not and does not represent a financial claim on, or a liability of, any identifiable entity.” This definition shifts the focus toward the regulatory, economic, and business dimensions of crypto-assets rather than the specific technologies enabling them. Unlike traditional financial instruments, crypto-assets do not represent a legal claim to any identifiable counterparty. Their value is derived entirely from users’ collective expectations that others will recognize and trade them in the future rather than from any promise of cash flows or underlying assets.
The core feature distinguishing crypto-assets is that they do not constitute a claim against an issuer or custodian. Despite this, users assign value to these assets because they believe the supply will remain limited and because there is a reliable mechanism to prove ownership and transfer rights. The interplay of scarcity and verifiable ownership allows a market to exist where participants on the supply side can offer their holdings for sale while those on the demand side can bid for them. Traditionally, the legitimacy of ownership and issuance would be safeguarded by a trusted central authority, such as a notary or custodian. In the digital world, however, counterfeiting becomes trivially easy—mere copying and pasting—thus making centralized oversight critical for conventional digital assets.
In the crypto-asset ecosystem, cryptographic techniques replace the traditional central authority. Cryptography ensures that no unauthorized issuance occurs and that users can independently agree on ownership without relying on a trusted intermediary. Distributed Ledger Technology (DLT) enables this by distributing the recording and validation of transactions across a network of users who may not know or trust each other. In unrestricted DLT networks—commonly used for crypto-assets—anyone can participate without proof of identity. Transactions are validated through consensus mechanisms where users collectively approve changes to the ledger. The validation process is structured to minimize the risk that a single user or small group can control the network.
Nonetheless, open DLT systems face significant governance challenges. In these decentralized environments, validation is often the only tool available to reach an agreement on ledger changes. Coordinating updates or protocol modifications is inherently tricky because there is no central authority to enforce rules. Even when a majority of users agree on changes, others may choose to maintain the original protocol, resulting in a “fork.” Forks create two diverging sets of ownership records, which may never reconcile, complicating the usability and trustworthiness of the crypto-asset involved.
It is important to note that simply recording an asset using DLT does not change its economic or legal nature. The same regulatory frameworks that apply to non-DLT digital assets would still apply if the asset constitutes a claim on an identifiable entity. Therefore, assets such as financial instruments, electronic money, commercial bank money, and even potential central bank digital currencies (CBDCs) fall outside the scope of the ECB’s definition of crypto-assets. This analysis focuses strictly on those digital assets that do not represent claims on an issuer and derive their value purely from user consensus rather than legal rights or promised financial returns.
Frequently Asked Question
What are the main types of crypto losses covered in Part 2?
Part 2 discusses additional types of deductible crypto losses, focusing on investment theft losses under IRC Sec. 165(c)(2) and the possibility of recognizing losses through abandonment of crypto assets. It also explores the legal standards that must be met to qualify for tax deductions.
Can FTX account holders claim a theft loss for tax purposes?
Possibly, but it isn’t very easy. To claim a theft loss, FTX users must prove that their losses resulted from an actual theft under state law and must reasonably determine the value of their unrecoverable losses. The situation is still evolving, and IRS guidance may be issued.
How does an “investment theft loss” differ from a regular theft loss?
An investment theft loss specifically relates to losses involving investments made with the expectation of profit. Unlike personal casualty or theft losses (which are suspended until after 2025), investment theft losses are currently deductible as ordinary losses.
What IRS forms are used to report a crypto theft loss?
If you qualify for an investment theft loss, you would typically report it on Form 4684 (Casualties and Thefts) as part of your itemized deductions. Proper documentation and calculations are critical.
What is the “abandonment” method for recognizing crypto losses?
If theft loss is too uncertain, a taxpayer may alternatively treat a crypto asset as abandoned. Abandonment involves intentionally giving up ownership without receiving compensation, potentially triggering an ordinary loss reported on Form 4797.
How can a crypto investor show intent to abandon an asset?
A taxpayer must demonstrate clear intent to abandon and take affirmative action to relinquish the asset. In some cases, this might involve notifying a bankruptcy trustee or transferring the worthless crypto to a “null” wallet.
Are abandoned crypto losses treated as capital losses or ordinary losses?
It depends. Proper abandonment (with no compensation or liability relief) can qualify for ordinary loss treatment. However, if the asset is sold for even a minimal amount or transferred improperly, the loss may be treated as a capital loss instead.
Conclusion
Understanding the different types of crypto losses is essential for investors seeking to manage the financial impact of events like the FTX collapse. As discussed in Part 2, there are potential avenues for claiming investment theft losses or abandonment losses. Still, each path comes with its own set of legal standards, documentation requirements, and strategic considerations. The distinction between ordinary and capital loss treatment can significantly affect the tax outcome.
Given the ongoing investigations and the possibility of new IRS guidance, crypto investors must proceed cautiously. Working closely with a qualified tax advisor is critical to ensure that any loss claims are correctly substantiated and optimally positioned for tax benefits. As the regulatory and legal landscape continues to evolve, staying informed and proactive will help investors make sound decisions and potentially recover part of their losses through appropriate tax strategies.