Can You Deduct the Theft or Loss of Cryptocurrency? “The Paradox on Anonymity”

Can You Deduct the Theft or Loss of Cryptocurrency? “The Paradox on Anonymity”
By: Sanford I. Millar

According to an article in the WSJ 07/08/18 “A Fifth of All Bitcoin Is Missing”. If for simple illustration we assume that there is 20 million BTC in circulation then one fifth is 4 million BTC. At today’s price of approximately $6,500 USD that is approximately USD $26 billion in lost BTC. Some of these “coins” were stolen in well publicized thefts from public exchanges, and some were simply lost as a result of people forgetting or losing their passwords. If the owners of these “lost or stolen” BTC or other cryptocurrencies want to deduct their loses as a “theft” loss or “casualty” loss they may face serious obstacles if they were not reporting their cryptocurrency income on their federal and state tax income tax returns.

In a Notice issued July 2, 2018, the IRS stated the following:
“U.S. persons are subject to tax on worldwide income from all sources including transactions involving virtual currency. IRS Notice 2014-21 states that virtual currency is property for federal tax purposes and provides information on the U.S. federal tax implications of convertible virtual currency transactions. The Virtual Currency Compliance campaign will address noncompliance related to the use of virtual currency
through multiple treatment streams including outreach and examinations. The compliance activities will follow the general tax principles applicable to all transactions in property, as outlined in Notice 2014-21.”

There are two key points from the above cited Notice. First is that virtual currency (aka cryptocurrency) is considered by the IRS and treated as “property” and is therefore subject to the theft and casualty loss deduction rules. And second, U.S. persons are subject to taxation on their worldwide income. That means that holders of virtual currency must maintain proper books and records that accurately report purchases and sales and then report gain or loss on their income tax returns. Remember, you sign your tax returns under “penalty of perjury”. This last point is important as discussed below.

To deduct a loss of cryptocurrency a taxpayer must meet specific requirements. The IRS published the criteria in it s list of Tax Topics (#515) which are as follows:

“Casualty Losses – A casualty loss can result from the damage, destruction, or loss of your property from any sudden, unexpected, or unusual event such as a flood, hurricane, tornado, fire, earthquake, or volcanic eruption. A casualty doesn’t include normal wear and tear or progressive deterioration.
If your property is personal-use property or isn’t completely destroyed, the amount of your casualty loss is the lesser of:
• The adjusted basis of your property, or
• The decrease in fair market value of your property as a result of the casualty
If your property is business or income-producing property, such as rental property, and is completely destroyed, then the amount of your loss is your adjusted basis.
Theft Losses – A theft is the taking and removal of money or property with the intent to deprive the owner of it. The taking must be illegal under the law of the state where it occurred and must have been done with criminal intent.
The amount of your theft loss is generally the adjusted basis of your property because the fair market value of your property immediately after the theft is considered to be zero.”
If a U.S. taxpayer has not previously reported income (gain or loss) and/or expenses associated with the their ownership of cryptocurrency, based upon the mistaken belief that the anonymous holding of such “property” enables them to avoid reporting, that same U.S. taxpayer may be unable to claim the theft or casualty loss and at the same may face criminal and/or civil tax penalties if they try to take the losses anyway.

Remember, that you sign your returns “under penalty of perjury” well, the key element is criminal tax prosecutions is establishing “Willfulness”. The filing of a tax return which includes virtual currency theft or casualty loss will be definition establish the year(s) in which the virtual currency was purchased and its cost basis, including the number of virtual currency units involved in each purchase, the number of units stolen or lost and the value at the date of the event, among other facts. A taxpayer making such a claim should expect a thorough audit and examination of the taxpayers books and records and including domestic and foreign financial account records and a review of “information returns” required under the Internal Revenue Code (such as Form 8938 Statement of Specified Foreign Financial Assets) and in some cases Bank Secrecy Act filings (FBARs). The failure to report income coupled with the absence of “Information Returns” may result in a “fraud referral” meaning a possible criminal tax evasion prosecution or a civil fraud penalty as well as denial of the claimed loss.

If you are a victim of a virtual currency “theft” or have simply lost your password (key), you should consult with skilled tax counsel to determine the best method of coming forward and claiming the losses as well a making sure that you are otherwise tax compliant