How to Handle Taxes and Reporting in Bankruptcy or Loss Due to Exchanges Failing

by
Pratibha Tiwari
Reviewed by
min read
Last updated:

Crypto prices crashed back in 2022 because multiple centralised crypto exchanges filed for bankruptcy simultaneously. The crypto market in its entirety suffered gravely from rising inflation rates, Terra Luna's collapse, and the catastrophic downfall of SBF’s FTX exchange.

The crypto market cap stood at $3 Trillion back in 2021 and it’s a little over $1.2 Trillion at the time of writing. Bitcoin’s price is almost 1/3rd of what it was at the peak of the dream crypto run. Crypto happens to be one of the most popular investment avenues for retail investors across the united states. According to a report by Poweresearch, more than 16% of Americans have personally traded or invested in crypto, despite the high-risk profile of the asset.

With exchanges collapsing one after the other, these investors have no choice but to worry about how to claim deductions on their tax reports to at least minimise the losses to some degree. If you happen to be one of those investors, you’re in the right place because we’re going to look at all the major collapses and their bankruptcy proceedings, and will then move on to how you can recoup these losses.

So without beating around the bush, let’s get started…

Why did it happen?

The crypto industry's downfall was the result of multiple events that occurred one after the other. However, one event, in particular, tipped the scale towards the wrong direction. The Terralabs(Luna) collapse. 

The Luna collapse was a truly significant event that negatively impacted the crypto space owing to the size and unexpectedness of the event. Terralabs UST token was a stablecoin(a non-volatile cryptocurrency pegged against $1) which was stabilised by another token called LUNA. LUNA and UST were associated in a way that any UST holder could swap 1 UST token for $1 worth of LUNA tokens.

Terralabs attracted a lot of attention towards the UST token by offering a staggering 20% annual interest to anyone who staked their UST tokens for a fixed period to stabilise the blockchain. On May 7, 2022, more than $2 billion worth of UST tokens were unstacked and swapped for LUNA tokens within 24 hours and UST tokens lost their dollar peg by 10 cents to dollar. 

This proved to be catastrophic for Terralabs as users started swapping UST tokens for LUNA tokens immediately, flooding the market with more LUNA tokens than there was a demand for and within hours LUNA tokens lost 99.99% of their value, bringing mayhem to an end.

3AC (3 Arrows Capital- one of the leading investment funds) was one of the primary investors in UST.

What happened to 3AC?

3AC had invested $200 million into LUNA, and all of that was gone within a few hours. They also had $10 billion in other crypto assets under management, but rising interest rates and the overall effect of the LUNA crash on the crypto market led to 3AC filing for bankruptcy on July 1, 2022. At the time of filming bankruptcy 3AC had the biggest names in the crypto space like Celsius, Voyager, BlockFI, and Genesis as its creditors.

The Final Piece: FTX Collapse

Alameda Research, an investment fund and a sister company to one of the biggest crypto exchanges in the US at the time, FTX, was also caught up in the Luna collapse, which led to a liquidity crunch for Alameda. FTX loaned investor deposits to Alameda to help fund the insolvency, but as soon as the news hit the street, Binance announced that it was going to sell $585 million worth of FTT tokens. What followed was a classic bank run on FTX and the exchange had to go for a bankruptcy filing on November 11.

What followed was a chain reaction:

  • Celsius and Voyager both filed for bankruptcy as they were creditors to 3AC
  • Since BlockFi was right in the middle of being sold to FTX, they had to follow suit and file for bankruptcy as well
  • Genesis Global halted operations under a lot of pressure on November 16, 2023

Bankruptcy Procedures and Their Implications

Investors stuck in the middle of collapsed exchanges and bankruptcy procedures often end up waiting for a legal settlement in hopes of recovering at least some of their funds, but the only issue with this approach is that bankruptcy proceedings take years to conclude. For instance, Enron took 7 years to reach a $7.2 billion settlement, and another crypto exchange called Mt. Gox filed for bankruptcy back in 2014 and is yet to pay any compensation to any of its creditors or shareholders.

Moreover, there’s this concept of secured and unsecured creditors. Creditors with security interests receive priority in repayment, whereas unsecured creditors can only expect to be repaid on a voluntary basis following a judgment in their favor. If the exchange fails to pay the settlement amount you can sue them in court for the money. The best way to know whether you’re a secured or unsecured creditor is to contact an attorney and substantiate your position.

Experts predict that 40-50% of the funds locked with FTX are recoverable, however, that may take time judging from how past events have unfolded.

Your next Step (Tax Options and Legal Considerations)

For people stuck in the middle of bankruptcy proceedings and troubles in crypto exchanges, here are all your legal and tax options that you can explore to minimise your losses or recover your lost funds.

Casualty or Crypto Theft Loss

Sam Bankman-Fried’s actions led to FTX's collapse. By lending investor deposits to Almaeda, SBF went against company policies and betrayed the trust of customers, which is a clear case of fraud and the losses can be claimed as a deduction. But according to the Tax Cuts and Jobs Act of 2017, there’s a 2% ceiling on the itemised deductions and coincidentally crypto theft losses fall under itemised deductions, and since losses due to fraud or theft can only be claimed in the year they occurred, reporting these losses would have zero impact on your tax bill.

Bad-Debt Loss (Non-Business)

According to IRC Section 166(D), bad debts can be used as a deduction on tax bills given that the creditor may prove a creditor-debitor relationship and the status of the loan is wholly worthless. Partial deductions are not allowed in case of bad loans. Note that even individuals can claim bad-debt deductions in a non-business setting. The Celsius case for instance offers a solid premise for a debitor-creditor relationship because the terms and conditions of Celsius state that any assets transferred to the platform in an attempt to earn constitutes a loan from the user to the platform and you can use this to your advantage and claim a tax deduction.

Worthless Investment

According to IRC Section 165(G), worthless securities can be used as a deduction. The only problem is that the IRC doesn’t consider crypto to be a form of security and classifies it as a capital asset, thus making this option inaccessible for crypto investors.

Abandonment Losses and Deductions

According to the IRC section 165(A), abandonment losses can be claimed as a deduction, if the following conditions are met:

  1. Proof of ownership of abandoned assets
  2. Proof of intent to abandon the asset
  3. Active attempt to abandon the asset

If you can prove all three and back them up with relevant documents, you can claim a deduction. For insolvencies involving multiple cryptocurrency exchanges, it's wise to keep records of purchases on each platform to establish ownership. To demonstrate intent to abandon, written documentation of conversations with legal counsel and bankruptcy entities may be necessary. Accurate records of transactions and claimed deductions are critical, and taxpayers should download their transaction history before losing access to their accounts.

Loss Due to Ponzi Schemes

According to the IRS Revenue Ruling 2009-9 offers relief to victims of Ponzi schemes. The example describes what happens when you end up investing in a Ponzi Scheme.

If investor A opened an investment account with B, giving B power of attorney to purchase and sell securities on A's behalf. A contributed a total of $120x and reinvested any earnings. B provided account and tax reporting statements that reflected gains and losses. In Year 7, A took a distribution of $30x. In Year 8, it was discovered that B's investment advisory was a fraudulent "Ponzi" scheme. A can report a loss equal to his/her initial investment.

But the bigger question is whether the FTX collapse can be considered a Ponzi scheme. According to Ruling 77-17, officers involved in fraudulent activities are not enough for the event to be categorized as a Ponzi Scheme.

Claiming the Loss is Not Always the Best Approach

Sometimes waiting for the settlement can be a better choice for you. Consider the following example:

Suppose Taxpayer B had $5,000 on Bitstamp and a tax rate of 25%. If B claims an ordinary loss of $5,000 under the abandonment of intangibles rules, the taxpayer could get a tax benefit of $1,250 (5,000 x 25%). Waiting for the completion of the Bitstamp bankruptcy proceedings could result in a better cash position, and the taxpayer might also be able to claim a $3,000 capital loss on top of the $2,000 received due to the bankruptcy proceedings. Nonetheless, taxpayers should consider the time value of money and the length of the bankruptcy proceedings before deciding whether to wait.

FAQs

1. How does a crypto exchange failure affect me?

A crypto exchange failure can have various impacts on investors. It can result in a loss of assets, which can have financial implications. Additionally, investors may face challenges in accessing their funds or recovering their losses due to the legal and regulatory complexities involved in crypto exchanges. For tax purposes, investors may be able to claim a tax deduction for losses due to a crypto exchange failure, but the process of claiming the deduction can be complex and time-consuming. It is important to keep accurate records and seek professional advice to navigate the tax implications of a crypto exchange failure. Overall, it is essential to exercise caution and diligence when investing in cryptocurrencies and to carefully consider the risks involved.

2. How are losses due to a crypto exchange failure treated for tax purposes?

For tax purposes, losses due to a crypto exchange failure may be treated as a capital loss, which can be used to offset capital gains or, in certain circumstances, up to $3,000 of ordinary income per year. The specific tax treatment of losses due to a crypto exchange failure can depend on various factors, including the taxpayer's tax situation and the timing and nature of the loss.

It is important to keep accurate records of all transactions and communications related to the exchange failure, including any attempts to recover lost funds. Taxpayers should also consult with a tax professional for guidance on how to properly report the loss and claim any available tax deductions or credits.

3. How long does it take to claim a tax deduction for losses due to a crypto exchange failure?

The process of claiming a tax deduction for losses due to a crypto exchange failure can be complex and time-consuming, and the timeframe for claiming the deduction can vary depending on the specific circumstances of the loss.

In general, taxpayers must first establish that a loss has occurred and determine the amount of the loss. This may involve documenting transactions, communications with the exchange, and any attempts to recover lost funds.

Once the loss has been established, taxpayers must determine whether it qualifies as a capital loss or an ordinary loss, which can depend on factors such as the taxpayer's tax situation and the timing and nature of the loss.

After determining the type of loss, taxpayers must properly report the loss on their tax return, which may involve completing additional forms and providing supporting documentation.

Overall, the timeframe for claiming a tax deduction for losses due to a crypto exchange failure can vary depending on the complexity of the situation and the amount of documentation required. It is essential to consult with a tax professional for guidance on how to properly report the loss and claim any available tax deductions or credits.

All content on Kryptos serves general informational purposes only. It's not intended to replace any professional advice from licensed accountants, attorneys, or certified financial and tax professionals. The information is completed to the best of our knowledge and we at Kryptos do not claim either correctness or accuracy of the same. Before taking any tax position / stance, you should always consider seeking independent legal, financial, taxation or other advice from the professionals. Kryptos is not liable for any loss caused from the use of, or by placing reliance on, the information on this website. Kryptos disclaims any responsibility for the accuracy or adequacy of any positions taken by you in your tax returns. Thank you for being part of our community, and we're excited to continue guiding you on your crypto journey!

How we reviewed this article

Written by
Pratibha Tiwari

Content Creator - Kryptos, An engineer who transitioned to become a Web3 Content Writer and Creator, has contributed to core marketing teams of renowned Web3 projects.

Reviewed by

Arrow

How to Handle Taxes and Reporting in Bankruptcy or Loss Due to Exchanges Failing

By
Pratibha Tiwari
On

Crypto prices crashed back in 2022 because multiple centralised crypto exchanges filed for bankruptcy simultaneously. The crypto market in its entirety suffered gravely from rising inflation rates, Terra Luna's collapse, and the catastrophic downfall of SBF’s FTX exchange.

The crypto market cap stood at $3 Trillion back in 2021 and it’s a little over $1.2 Trillion at the time of writing. Bitcoin’s price is almost 1/3rd of what it was at the peak of the dream crypto run. Crypto happens to be one of the most popular investment avenues for retail investors across the united states. According to a report by Poweresearch, more than 16% of Americans have personally traded or invested in crypto, despite the high-risk profile of the asset.

With exchanges collapsing one after the other, these investors have no choice but to worry about how to claim deductions on their tax reports to at least minimise the losses to some degree. If you happen to be one of those investors, you’re in the right place because we’re going to look at all the major collapses and their bankruptcy proceedings, and will then move on to how you can recoup these losses.

So without beating around the bush, let’s get started…

Why did it happen?

The crypto industry's downfall was the result of multiple events that occurred one after the other. However, one event, in particular, tipped the scale towards the wrong direction. The Terralabs(Luna) collapse. 

The Luna collapse was a truly significant event that negatively impacted the crypto space owing to the size and unexpectedness of the event. Terralabs UST token was a stablecoin(a non-volatile cryptocurrency pegged against $1) which was stabilised by another token called LUNA. LUNA and UST were associated in a way that any UST holder could swap 1 UST token for $1 worth of LUNA tokens.

Terralabs attracted a lot of attention towards the UST token by offering a staggering 20% annual interest to anyone who staked their UST tokens for a fixed period to stabilise the blockchain. On May 7, 2022, more than $2 billion worth of UST tokens were unstacked and swapped for LUNA tokens within 24 hours and UST tokens lost their dollar peg by 10 cents to dollar. 

This proved to be catastrophic for Terralabs as users started swapping UST tokens for LUNA tokens immediately, flooding the market with more LUNA tokens than there was a demand for and within hours LUNA tokens lost 99.99% of their value, bringing mayhem to an end.

3AC (3 Arrows Capital- one of the leading investment funds) was one of the primary investors in UST.

What happened to 3AC?

3AC had invested $200 million into LUNA, and all of that was gone within a few hours. They also had $10 billion in other crypto assets under management, but rising interest rates and the overall effect of the LUNA crash on the crypto market led to 3AC filing for bankruptcy on July 1, 2022. At the time of filming bankruptcy 3AC had the biggest names in the crypto space like Celsius, Voyager, BlockFI, and Genesis as its creditors.

The Final Piece: FTX Collapse

Alameda Research, an investment fund and a sister company to one of the biggest crypto exchanges in the US at the time, FTX, was also caught up in the Luna collapse, which led to a liquidity crunch for Alameda. FTX loaned investor deposits to Alameda to help fund the insolvency, but as soon as the news hit the street, Binance announced that it was going to sell $585 million worth of FTT tokens. What followed was a classic bank run on FTX and the exchange had to go for a bankruptcy filing on November 11.

What followed was a chain reaction:

  • Celsius and Voyager both filed for bankruptcy as they were creditors to 3AC
  • Since BlockFi was right in the middle of being sold to FTX, they had to follow suit and file for bankruptcy as well
  • Genesis Global halted operations under a lot of pressure on November 16, 2023

Bankruptcy Procedures and Their Implications

Investors stuck in the middle of collapsed exchanges and bankruptcy procedures often end up waiting for a legal settlement in hopes of recovering at least some of their funds, but the only issue with this approach is that bankruptcy proceedings take years to conclude. For instance, Enron took 7 years to reach a $7.2 billion settlement, and another crypto exchange called Mt. Gox filed for bankruptcy back in 2014 and is yet to pay any compensation to any of its creditors or shareholders.

Moreover, there’s this concept of secured and unsecured creditors. Creditors with security interests receive priority in repayment, whereas unsecured creditors can only expect to be repaid on a voluntary basis following a judgment in their favor. If the exchange fails to pay the settlement amount you can sue them in court for the money. The best way to know whether you’re a secured or unsecured creditor is to contact an attorney and substantiate your position.

Experts predict that 40-50% of the funds locked with FTX are recoverable, however, that may take time judging from how past events have unfolded.

Your next Step (Tax Options and Legal Considerations)

For people stuck in the middle of bankruptcy proceedings and troubles in crypto exchanges, here are all your legal and tax options that you can explore to minimise your losses or recover your lost funds.

Casualty or Crypto Theft Loss

Sam Bankman-Fried’s actions led to FTX's collapse. By lending investor deposits to Almaeda, SBF went against company policies and betrayed the trust of customers, which is a clear case of fraud and the losses can be claimed as a deduction. But according to the Tax Cuts and Jobs Act of 2017, there’s a 2% ceiling on the itemised deductions and coincidentally crypto theft losses fall under itemised deductions, and since losses due to fraud or theft can only be claimed in the year they occurred, reporting these losses would have zero impact on your tax bill.

Bad-Debt Loss (Non-Business)

According to IRC Section 166(D), bad debts can be used as a deduction on tax bills given that the creditor may prove a creditor-debitor relationship and the status of the loan is wholly worthless. Partial deductions are not allowed in case of bad loans. Note that even individuals can claim bad-debt deductions in a non-business setting. The Celsius case for instance offers a solid premise for a debitor-creditor relationship because the terms and conditions of Celsius state that any assets transferred to the platform in an attempt to earn constitutes a loan from the user to the platform and you can use this to your advantage and claim a tax deduction.

Worthless Investment

According to IRC Section 165(G), worthless securities can be used as a deduction. The only problem is that the IRC doesn’t consider crypto to be a form of security and classifies it as a capital asset, thus making this option inaccessible for crypto investors.

Abandonment Losses and Deductions

According to the IRC section 165(A), abandonment losses can be claimed as a deduction, if the following conditions are met:

  1. Proof of ownership of abandoned assets
  2. Proof of intent to abandon the asset
  3. Active attempt to abandon the asset

If you can prove all three and back them up with relevant documents, you can claim a deduction. For insolvencies involving multiple cryptocurrency exchanges, it's wise to keep records of purchases on each platform to establish ownership. To demonstrate intent to abandon, written documentation of conversations with legal counsel and bankruptcy entities may be necessary. Accurate records of transactions and claimed deductions are critical, and taxpayers should download their transaction history before losing access to their accounts.

Loss Due to Ponzi Schemes

According to the IRS Revenue Ruling 2009-9 offers relief to victims of Ponzi schemes. The example describes what happens when you end up investing in a Ponzi Scheme.

If investor A opened an investment account with B, giving B power of attorney to purchase and sell securities on A's behalf. A contributed a total of $120x and reinvested any earnings. B provided account and tax reporting statements that reflected gains and losses. In Year 7, A took a distribution of $30x. In Year 8, it was discovered that B's investment advisory was a fraudulent "Ponzi" scheme. A can report a loss equal to his/her initial investment.

But the bigger question is whether the FTX collapse can be considered a Ponzi scheme. According to Ruling 77-17, officers involved in fraudulent activities are not enough for the event to be categorized as a Ponzi Scheme.

Claiming the Loss is Not Always the Best Approach

Sometimes waiting for the settlement can be a better choice for you. Consider the following example:

Suppose Taxpayer B had $5,000 on Bitstamp and a tax rate of 25%. If B claims an ordinary loss of $5,000 under the abandonment of intangibles rules, the taxpayer could get a tax benefit of $1,250 (5,000 x 25%). Waiting for the completion of the Bitstamp bankruptcy proceedings could result in a better cash position, and the taxpayer might also be able to claim a $3,000 capital loss on top of the $2,000 received due to the bankruptcy proceedings. Nonetheless, taxpayers should consider the time value of money and the length of the bankruptcy proceedings before deciding whether to wait.

FAQs

1. How does a crypto exchange failure affect me?

A crypto exchange failure can have various impacts on investors. It can result in a loss of assets, which can have financial implications. Additionally, investors may face challenges in accessing their funds or recovering their losses due to the legal and regulatory complexities involved in crypto exchanges. For tax purposes, investors may be able to claim a tax deduction for losses due to a crypto exchange failure, but the process of claiming the deduction can be complex and time-consuming. It is important to keep accurate records and seek professional advice to navigate the tax implications of a crypto exchange failure. Overall, it is essential to exercise caution and diligence when investing in cryptocurrencies and to carefully consider the risks involved.

2. How are losses due to a crypto exchange failure treated for tax purposes?

For tax purposes, losses due to a crypto exchange failure may be treated as a capital loss, which can be used to offset capital gains or, in certain circumstances, up to $3,000 of ordinary income per year. The specific tax treatment of losses due to a crypto exchange failure can depend on various factors, including the taxpayer's tax situation and the timing and nature of the loss.

It is important to keep accurate records of all transactions and communications related to the exchange failure, including any attempts to recover lost funds. Taxpayers should also consult with a tax professional for guidance on how to properly report the loss and claim any available tax deductions or credits.

3. How long does it take to claim a tax deduction for losses due to a crypto exchange failure?

The process of claiming a tax deduction for losses due to a crypto exchange failure can be complex and time-consuming, and the timeframe for claiming the deduction can vary depending on the specific circumstances of the loss.

In general, taxpayers must first establish that a loss has occurred and determine the amount of the loss. This may involve documenting transactions, communications with the exchange, and any attempts to recover lost funds.

Once the loss has been established, taxpayers must determine whether it qualifies as a capital loss or an ordinary loss, which can depend on factors such as the taxpayer's tax situation and the timing and nature of the loss.

After determining the type of loss, taxpayers must properly report the loss on their tax return, which may involve completing additional forms and providing supporting documentation.

Overall, the timeframe for claiming a tax deduction for losses due to a crypto exchange failure can vary depending on the complexity of the situation and the amount of documentation required. It is essential to consult with a tax professional for guidance on how to properly report the loss and claim any available tax deductions or credits.

All content on Kryptos serves general informational purposes only. It's not intended to replace any professional advice from licensed accountants, attorneys, or certified financial and tax professionals. The information is completed to the best of our knowledge and we at Kryptos do not claim either correctness or accuracy of the same. Before taking any tax position / stance, you should always consider seeking independent legal, financial, taxation or other advice from the professionals. Kryptos is not liable for any loss caused from the use of, or by placing reliance on, the information on this website. Kryptos disclaims any responsibility for the accuracy or adequacy of any positions taken by you in your tax returns. Thank you for being part of our community, and we're excited to continue guiding you on your crypto journey!

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