Taxpayers who lost money in FTX must wait on answers

When the FTX cryptocurrency exchange collapsed into bankruptcy in November, the company and its affiliates reportedly owed money to more than one million creditors, many of whom are U.S. customers who used the platform to hold and trade digital assets like Bitcoin and Ether. FTX’s massive size and broad customer base has many U.S. tax professionals wondering what to tell clients who may have held assets in the exchange but can no longer access their accounts.

The good news is that, while it is not clear how the losses will be reported, it does look like U.S. customers will be able to claim at least some of their losses on their federal income tax returns. Unfortunately, with FTX winding its way through a bankruptcy process that may take years to resolve, it is unlikely that the size of the losses individual customers may claim will be established before U.S. taxpayers will need to file their 2022 returns in April 2023.

Many customers probably assume the assets they held in FTX are currently worthless and that they will be able to claim a total loss on their investment this year. However, while the company is still in bankruptcy, there remains a possibility that customers will be able to recoup at least some of their lost investment. That possibility is likely to keep the IRS from allowing taxpayers to claim a total loss on the assets they held in FTX and force them to wait out the bankruptcy process.

Capital or theft loss?
Until FTX founder Sam Bankman-Fried was indicted for his role in the events leading up to FTX’s collapse, it was looking like taxpayers could claim capital losses on the investments they held in the exchange. Capital losses can be used to offset capital gains. Taxpayers without capital gains to offset can use their capital losses to offset up to $3,000 in ordinary income a year with any unused amounts carried forward to future years.

However, since Bankman-Fried illegally diverted assets investors held in FTX to his Alameda Research hedge fund, it is possible that the IRS will take the position that Bankman-Fried was operating FTX as a Ponzi scheme. The IRS has special rules in place that allow victims of a Ponzi scheme to deduct their losses as theft losses and avoid the usual rules on using a capital loss to offset ordinary income. There is no limit on the size of the ordinary income deduction that may be claimed by a Ponzi victim in a tax year.

Will customer records be public?
FTX customers may be facing more problems than simply losing the assets held in the exchange. In the U.S. bankruptcy system, unless a judge orders the records sealed, all documents are available for public viewing. FTX has maintained that releasing those records would hurt its efforts to find a buyer for the company, violate privacy laws and expose customers to scams.

But a group of media companies are asking the bankruptcy judge to make FTX’s bankruptcy records public. They claim its customers are bankruptcy creditors and it is important to the bankruptcy process for the public to know how much money each FTX creditor is receiving. A judge is expected to hear arguments in the case Jan. 11, 2023.

If you are looking for more information on virtual currencies and how they are taxed, check out our on-demand webinar on the subject. The webinar is free to our premium members.