So you had an investment in the FTX cryptocurrency exchange? Now that we’ve watched the spectacular collapse and bankruptcy filing, you may be wondering what all this means for tax purposes. Can we turn this loss into something that will lower your tax bill? Spoiler alert – “It depends” and “We don’t know yet”….
Before we explain the potential FTX treatment, it is helpful to review how investment losses are normally treated for US tax purposes.
Investment losses are generally treated as capital losses for tax purposes. Capital losses occur when you sell a capital asset, such as stocks, bonds or real estate, for a lower price than you paid for it. The difference between the sale price and the purchase price is your capital loss.
Capital losses can be used to offset capital gains, which are profits from the sale of capital assets. If you have more capital losses than capital gains in a tax year, you can use the excess capital losses to offset up to $3,000 of ordinary income. Any remaining capital losses can be carried forward to future tax years and used to offset future capital gains or ordinary income.
Capital losses aren’t ideal due to this limitation. And – in order to lock in your loss, you need to actually sell your investment. To do that you would actually need to be able to login to your account, which isn’t currently possible. So what are our other options?
Investment Theft Losses
It turns out that the IRS has helped out some past investors in a tough spot with Revenue Ruling 2009-09 and Revenue Procedure 2009-20. While the IRS isn’t often known to have a caring heart, it turns out that they have a soft spot for jilted investors. Who knew?
Both of these IRS communications deal with investment fraud and give us some insight into how the IRS views the taxable treatment of investments that later turn out to be fraudulent.
This deduction is most commonly associated with the Bernie Madoff Ponzi theft losses of the 2000s.
A Ponzi scheme is a fraudulent investment scheme that involves the use of money from new investors to pay the returns of earlier investors, without any actual underlying business or investment activity.
While “casualty and theft losses” of a personal nature are not currently deductible by individuals due to a moratorium on such losses with the Tax Cuts and Jobs Act that won’t end until after 2025, it may be possible to characterize such a loss as an “investment theft loss” under IRC Sec. 165(c)(2). This type of loss is not subject to the moratorium and results in an itemized deduction taken as an ordinary loss on Form 4684, Section C.
Form 4684 Requirements
There is a section of Form 4684 that requires you to attest to several items in order to take an ordinary income deduction on your return:
- You are following the rules of Revenue Procedure 2009-20 (more on that later)
- You have written documentation of your loss (you DID download your investment transaction history before the FTX website collapsed, right? RIGHT?)
- You are a qualified investor under 2009-20
- You don’t intend to pursue third party recovery (your deduction is limited to 75% of your investment if recovery is being pursued)
- And a few more items we’ll skip for brevity here (but be sure to read through them all if you are filing your own return)
Revenue Procedure 2009-20
In order to take advantage of ordinary loss treatment, we need to prove the following three items occurred:
- An indictment (seems like we’re working on that with the recent extradition of Sam Bankman-Fried from the Bahamas and the recent wire fraud indictment filed)
- The amount of the theft
- And the year in which the theft occurred
Generally, you can claim a tax deduction for a loss in the tax year in which the loss occurred. However, if you received any fraudulent conveyances (property or money transferred with the intent to defraud creditors) as part of the investment scheme, you may be required to report the fraudulent conveyance as income in the year in which you received it, even if you suffered a loss in a later year.
It is also important to keep accurate records and documentation of your FTX investment losses. This may include documents such as investment statements, bank records and other financial records that show the amount of your investment, the amount of your loss, and the timing of the loss. These records will be important in establishing the amount of your loss and claiming the appropriate tax deduction.
We are sure to see more guidance on this issue as we near the April tax deadline. With many open items, we recommend an extension of your return (as we do with all our client returns) so that you can optimize your tax deductions for this issue. Ideally we’ll know more soon on the chance of recovery which will ultimately help determine the maximum loss deduction available to investors.