The Tax Times: Tax Effect of Crypto Exchange Filing Bankruptcy

As another major cryptocurrency trading platform succumbs to market instability and files for bankruptcy in what has been a cataclysmic year for the industry, questions loom surrounding the tax implications for affected stakeholders.

On November 11, offshore crypto exchange FTX Trading Ltd. and the companies are known as the FTX Group, filed for Chapter 11 bankruptcy in the District of Delaware. Sam Bankman-Fried has resigned from his post as CEO, replaced by John Ray III, the group announced in a release posted on social media.

"The immediate relief of Chapter 11 is appropriate to provide the FTX Group the opportunity to assess its situation and develop a process to maximize recoveries for stakeholders," said Ray in the statement. He went on to ask for patience during the abrupt transition. Stakeholders are advised to monitor docket filings "over the coming days" for more details, Ray said.

Earlier this year, other exchanges like Celsius Network and Voyager Digital proceeded with their own bankruptcy filings. With FTX joining what is quickly becoming a crypto graveyard, stakeholders are left wondering when, or if, they will receive payouts.

Since There Is Little To No Precedent For Large-Scale Bankruptcy In The Industry, The Tax Consequences
For Investors And Other Stakeholders Are Unclear Due
To The Nature Of The Technologies Surrounding
Cryptocurrency And Their Classification As Property.

During bankruptcy proceedings, it will be decided which customers would be eligible as creditors and even as a creditor, the customer should be considered an unsecured creditor.

It remains to be seen if payouts would come in the form of crypto, or fiat currency, and how much and it is less clear is the timing of when assets would be valued.

Over the course of 2022, cryptocurrency prices have dramatically declined. At the time of writing, Bitcoin, the most prominent stablecoin, is valued at less than $17,000. Bitcoin hit its all-time peak at approximately $69,000 in November 2021 and has steadily fallen since, an industry-wide downward trend.

Also unknown at this time is when losses of crypto assets will be assessed. If an exchange that has filed for bankruptcy pauses withdraws on its platform, customers are unable to access their assets. Yet, they have not yet incurred a loss, even though their assets are in locked in the exchange. A loss should not likely be recognized until after bankruptcy process concludes, as a loss cannot be deducted until it is finalized.

“If your funds become totally worthless and irrecoverable, you may be eligible to write them off as a nonbusiness bad debt on your taxes,” said Shehan Chandrasekera, a certified public accountant, lead tax strategist at CoinTracker.io, a digital currency tax software company that helps clients track their crypto across virtual wallet addresses and manage their tax obligations.

You can think of a nonbusiness bad debt as a type of loss resulting from a debt extended to another party, which has been rendered totally worthless and irrecoverable. CPA Lewis Taub stressed to CNBC that there must be a complete loss of all that was lent to the platform in order for the debt to be considered deductible. Partial losses don’t count.

The Freezing Of Accounts, Or Limited Withdrawals By
Crypto Platforms, Does Not Constitute A Total Loss.

At this stage, many of the crypto platforms are still calling the freezes “temporary” as they figure out how to shore up some liquidity, whether through restructuring or securing additional lines of credit.

Chandrasekera says that a debt falls into this category of “totally uncollectible” only after all attempts at collection have failed. So technically, none of the crypto funds on deposit at these platforms are completely worthless. “It’s also deemed worthless if the borrower files for bankruptcy and the debt is discharged,” Chandrasekera explained.

However, Taub Told CNBC That Even If A Platform Declares Bankruptcy, The Holders May Still Get Something In Bankruptcy Court, So It’s Still Not A Total Loss.

Voyager Digital, for example, filed for Chapter 11 bankruptcy, but it’s not yet clear whether users will be able to recover some of their losses through this process.

Determining whether the cash you have given to a crypto platform constitutes a loan isn’t always straightforward. For example, crypto coins and stocks, both of which are considered to be nondebt instruments, do not qualify for this write-off.

“In order to have a nonbusiness bad debt, there needs to be an actual debtor-creditor relationship. So to the extent that crypto was loaned to a platform, that criteria is met,” said Taub, who is the director of tax services at Berkowitz Pollack Brant, to . Take Celsius. It spells out in its terms and conditions that any digital asset transferred to the platform constitutes a loan from the user to Celsius.

Not all platforms are this transparent in their terms and conditions, however. Neither Voyager nor BlockFi clearly describe the relationship that the user has with the platform, according to Chandrasekera.

Should the crypto lending platform meet the aforementioned criteria, an individual can report the initial value of the cryptocurrency (that is, the cost basis) when it was first lent to the platform as a short-term capital loss. There are certain capital loss limitations to keep in mind, namely the fact that nonbusiness bad debt is always considered a short-term capital loss.

As for the actual mechanics of reporting nonbusiness bad debt, the deduction goes on Form 8949 as a short-term capital loss. That’s where a user also files their crypto and stock gains and losses.

Chandrasekera notes that you have to attach a “bad debt statement” to the return explaining the nature of this loss, as well. Among other details, that must include “efforts you made to collect the debt and why you decided the debt was worthless.”

The IRS warns that if you later recover or collect some of the bad debt you’ve deducted, you might have to include it in your gross income.

Taub says that these days — to the extent that there are potential losses on actual holdings of crypto, he is advising clients to take advantage of the fact that “wash sale rules” do not apply to crypto. He tells CNBC that investors should really be watching their portfolio to consider “harvesting losses” to offset capital gains on other investments.

Because the IRS classifies digital currencies like bitcoin as property, losses on crypto holdings are treated much differently than losses on stocks and mutual funds, according to former Onramp Invest CEO Tyrone Ross. With crypto tokens, wash sale rules don’t apply, meaning that you can sell your bitcoin and buy it right back, whereas with a stock, you would have to wait 30 days to buy it back.

This nuance in the tax code is huge for crypto holders in the U.S., primarily because it paves the way for tax-loss harvesting.

This is a strategy that is catching on among CoinTracker users, according to Chandrasekera.

Have an IRS Tax Problem?