FTX founder Sam Bankman-Fried has received official criminal charges after the collapse of his cryptocurrency exchange, which is more than a moral victory for the exchange’s roughly 1 million individual investors. While not yet secured, things appear to be on track for these investors to take a more favorable fiscal position as SBF’s fate continues to unravel.

What types of losses can FTX investors claim on their taxes?

Earlier this fall, it appeared that the assets lost in the FTX collapse would be considered a capital loss under the United States tax code for tax year 2022. This capital loss can be used to offset capital gains. But in a year that saw the crypto market take a beating as a whole, most investors won’t have capital gains to make up for it in 2022.

A capital loss can also be used to offset “ordinary income,” such as money earned from a business or job, up to $3,000 per year. The loss carries over indefinitely, but if your loss in the FTX crash was substantial, it could take quite a while to reclaim it in full.

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A much more favorable scenario for many investors would be to claim a theft-loss deduction, which can offset ordinary income without any limit. Claiming a theft loss is normally a fairly difficult task that can attract scrutiny from the Internal Revenue Service. But the theft loss tax code contains a “safe harbor” for Ponzi schemes. For the most part, if an investor can show a loss in a Ponzi scheme, the IRS will not require additional documentation.

Was FTX a Ponzi scheme?

With investor assets illegally diverted to Alameda Research, SBF’s hedge fund, it seems likely that the IRS will eventually view FTX as a Ponzi scheme. To activate the safe harbor, FTX or its “main figure” SBF must be accused of fraud matching this description in the tax guide:

“A specified fraudulent agreement is an agreement in which one party (the main figure) receives cash or property from investors; intends to earn income for investors; reports amounts of income to investors that are partially or totally fictitious; makes payments, if any, of alleged income or principal to some investors from amounts that other investors invested in the fraudulent arrangement; and appropriates part or all of the cash or property of investors.

The charges that the SEC brought against SBF focus on equity investors, not retail investors. But the SEC specifically mentions “the undisclosed diversion of FTX client funds to Alameda Research.” While it’s not an official green light for safe harbor, it’s very close, closer than we’d hoped to see in 2022.

Outside of criminal charges, a criminal complaint along with a confession also activates the safe harbor of the Ponzi scheme. While he has been very vocal in the aftermath of the FTX collapse, SBF has given no indication that he plans to confess to anything.

What should FTX investors and their tax professionals do?

With the individual tax filing deadline of April 18, 2023, investors who lost assets in FTX have some time to see how this plays out. It seems very possible that the SEC will file additional charges against SBF or FTX that would clear up any doubts about the safe harbor of the Ponzi scheme.

The IRS can also weigh in on whether existing charges are enough to trigger safe harbor, and hopefully 2022 is the year to take it. The theft loss could also be claimed in a future year, but most FTX investors will likely be eager to recoup some of their losses by offsetting their tax proceeds as soon as possible.

Related: Before ETH Drops Further, Reserve Some Money for Surprise Taxes

For investors who lost assets in FTX, planning to claim the principal loss at this point would probably not be prudent. Even if, by some miracle, an investor has capital gains to offset after 2022, the ordinary income tax rate is much higher. The only scenario where this might make sense is if an individual had no ordinary income but had capital gains in 2022.

basis of comparison

In both scenarios (capital loss or Ponzi scheme safe harbor), it is important to note that the amount of loss allowed is the cost basis of the asset. Assuming the value you were able to extract from FTX after the crash is zero, you can claim the full amount you originally paid for the asset.

From the IRS’s point of view, your theft loss includes not only the full cost basis you paid, but you also get a boost for the income you paid taxes on. If you traded on the stock or had an income stream and recognized income for it on prior tax returns, and you did not withdraw from the stock before the crash, you must take that into account when calculating your cost basis. Your certified public accountant and/or coin trading software will probably come in handy here.

For some investors, the basis is likely to be more than the asset was worth when FTX caught fire, potentially a little more. That can be a bit of a silver lining here. And while it looked like investors would have to wait until 2023 to see if charges were filed in this matter, the SEC seems to have given them an early Christmas present.

Justin Wilcox is a partner at the Connecticut accounting and advisory firm Fiondella, Milone & LaSaracina. He founded the firm’s cryptocurrency practice in 2018, providing advisory and tax services to Web3 organizations and cryptocurrency investors. He mines and trades cryptocurrencies.

This article is for general information purposes and is not intended to be and should not be taken as legal or investment advice. The views, thoughts and opinions expressed herein are those of the author alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.

This post The outcome of the SBF prosecution could determine how the IRS treats your FTX losses

was published first on https://cointelegraph.com/news/sec-charges-are-a-tax-win-for-ftx-investors-who-lost-cash


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