Happy New $YEAR: How to Claim Crypto Losses on Your 2021 Tax Return | law of the free man

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2021 has been an incredible year for crypto investors. Tokens such as Polygon ($MATIC), Sandbox ($SAND), Decentraland ($MANA) have seen incredible gains, with investors realizing returns in excess of 100% of their initial investment. Still, investors could face a hefty tax bill for 2021, if they don’t plan accordingly.

Crypto investors weren’t the only category of people prosecuting. 2021 has also been a big year… for crypto scams. Epic failures such as Squid Game ($SQUID) have literally wiped out millions of dollars, resulting in substantial losses for thousands of investors. Launched on October 26, SQUID rose from $0.01 to a peak of $2,862 in one week, before falling to $0.00 after the developers performed what is commonly referred to as a “rug pull”. (meaning the developers are abandoning the project by selling their tokens and taking the investors’ money – hence “cutting the rug” under the investors’ money). In these cases, the investors holding the tokens suffer huge losses with no further possibility of recovery.

One of these “rug pulls” was done on the last day of 2021, in less than 6 hours. The $YEAR token was launched as the “year review” of the user’s Ethereum transaction history. The scam banned investors from selling because the token developer activated a certain code – embedded in the token software – preventing investors from selling their tokens and only allowing purchases. This caused the price to rise to 0.0009 ETH to fall to 0.000118 ETH and then to zero after the draw.

Investors should exercise caution and be aware of these scams in order to avoid monetary losses, but also to avoid unintended tax consequences, such as limits on the deduction of losses.

The Internal Revenue Code (IRC) offers two main ways to claim losses. Section 162 allows taxpayers to deduct ordinary and necessary expenses incurred in carrying on a trade or business. IRC § 162. Another provision that allows individuals to deduct losses is Section 165, which allows taxpayers to deduct losses incurred during the year and not compensated by insurance. IRC 165(a).

The first question in properly determining the tax treatment of a loss in cases such as $SQUID and $YEAR, is to determine whether an individual is engaged in a trade or business. If “yes”, the individual may be able to deduct the loss incurred in their business. Otherwise, the taxpayer must resort to section 165 to deduct the loss. A recent tax case, Antonyan, et. Al.v. Comm’r, TC Memo. 2021-138, gives an example of the requirements for deducting losses from a trade or business.

However, if the person is not carrying on a trade or business, but is instead an investor (like many crypto investors), the person may be required to use Section 165(c) to claim their losses.

Generally, Section 165(c) allows individuals to deduct losses incurred in a transaction entered into for profit, but unconnected with a trade or business, and property losses resulting from an accident, including theft.

Theft can include other criminal activities, for example theft, embezzlement and robbery. Treasures. Reg. 1.165-8(d). For example: token theft. In such cases, state law prevails and the individual must prove that the theft occurred under the law of the jurisdiction in which the alleged loss occurred, the amount of the loss and the date when the loss was discovered. See Monteleone v. Comm’r, 34 TC 688, 692 (1960). These rules can be difficult given the various elements that must be proven. For example, in a recent tax case, the Tax Court dismissed theft losses because under California law certain elements of the definition of theft were not found. See Ronnie S. Baum and Teresa K. Baum v. Comm’r, TC Memo 2021-46.

As discussed, investors victimized by rug draws, such as SQUID or YEAR, would have to demonstrate “theft” under state law. In addition, the amount of the loss and the precise date must be proven. Carpet draws present specific challenges as investors have acquired the tokens and therefore the definition of theft under the respective law may vary and may not include other cases such as embezzlement. Another challenge is determining the applicable law to characterize the theft when multiple jurisdictions are involved.

A final option potentially available to investors for deducting losses from theft is under the safe harbor provided by the Tax Procedure 2009-2020, which allows certain taxpayers to deduct losses from certain arrangements deemed to be criminally fraudulent.

As part of this tax procedure, various elements must be fulfilled. For example, there must be a “specified fraudulent arrangement” (an arrangement in which the main character – the scammer – receives money or property from investors or pretends to earn income for investors, among other things) and a qualified loss (a loss derived from the specified fraudulent arrangement where the scammer is charged with an indictment or is the subject of a state or federal criminal complaint alleging theft, among other things).

While Safe Harbor reduces some of the complications arising from Section 165(c), it presents its own challenges, particularly in cases of rug pulls. For example, the “qualified loss” may not be satisfied if there is no legal action by the government. In the case of SQUID, no government legal action has been taken to date (as of the date of this article). In the case of YEAR, the fact that the token was embedded with code may present difficulties in qualifying the scam as theft under state law.

As can be seen, individuals investing in crypto tokens should be aware of the tax implications of their losses. The ability to claim such losses may depend on various facts and circumstances. Proper tax and legal advice may be required to properly report these losses and avoid exposure to further liability, such as penalties, arising from these “knock-outs”.

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