Crypto lending platforms like Celsius, Anchorand digital travel has risen to prominence for offering almost unbelievable returns of up to 20% per annum on client deposits. Now, much of this crypto money is trapped, as falling token prices force platforms to temporarily suspend or limit withdrawals.
Following its own solvency crisis, Celsius — which is still advertising up to 18.63% annual return on its website – has had client funds on ice for more than three weeks and has yet to announce any tangible indications of next steps. So who is going to be left with the bag if these platforms go bankrupt?
Unlike the traditional banking system, which typically insures customer deposits, there is no formal consumer protection in place to safeguard user funds when things go wrong on decentralized finance platforms. “High risk, high reward” is the general motto of the DeFi ecosystem. For those who have lost their savings on these crypto lending platforms, there is little recourse to recoup their losses.
But Shehan Chandrasekera, a certified public accountant, told CNBC that the US tax code could provide some relief for such investors through an arcane deduction.
“If your funds become totally worthless and unrecoverable, you may be eligible to write them off as non-commercial bad debt on your taxes,” said Chandrasekera, who leads tax strategy at CoinTracker.ioa digital currency tax software company that helps customers track their crypto to virtual wallet addresses and manage their corresponding tax obligations.
“It won’t cover your entire economic loss, but it will give you some type of tax benefit because at least you can recoup that initial investment you made,” Chandrasekera continued.
You can think of a non-commercial bad debt as a type of loss resulting from a debt extended to another party, which has been rendered totally worthless and uncollectible.
CPA Lewis Taub points out that there must be a complete loss of everything loaned to the platform for the debt to be considered deductible. Partial losses do not count. Account freezes, or withdrawals restricted by crypto platforms, do not constitute a total loss.
At this point, many crypto platforms are still calling the freezes “temporary” as they look to shore up some liquidity, either by restructuring or securing additional lines of credit.
Chandrasekera says a debt falls into this category of “totally uncollectible” only after all attempts at collection have failed. So, technically, none of the crypto funds deposited on these platforms are completely worthless.
“It is also considered worthless if the borrower files for bankruptcy and the debt is discharged,” Chandrasekera said. explained in a tweet thread detailing how filers could claim the deduction.
However, Taub says that even if a platform declares bankruptcy, holders can still get something back in bankruptcy court, so it’s still not a total loss. Voyager Digital, for example, filed for Chapter 11 bankruptcy on Tuesday evening, but it’s not yet clear whether users will be able to recover some of their losses through this process.
Determining whether the money you gave to a crypto platform constitutes a loan is not always straightforward. For example, cryptocurrencies and stocks, which are both considered non-debt instruments, are not eligible for this delisting.
“To have a non-commercial bad debt, there must be a genuine debtor-creditor relationship. So to the extent that crypto has been loaned to a platform, that criteria is met,” said Taub, Chief Services Officer. tax at Berkowitz Pollack Brant, one of Florida’s largest accounting firms.
Take Celsius. It is stated in its terms and conditions that any digital asset transferred to the platform constitutes a loan from the user to Celsius.
Not all platforms are equally transparent in their terms and conditions. Neither Traveler neither BlockFi clearly describe the relationship the user has with the platform, according to Chandrasekera, who tells CNBC they may have left it vague because they don’t want to discuss it with the Securities and Exchange Commission.
This is also why CPAs are advising those affected by crypto platform suspensions to contact a financial advisor to see if their investment qualifies.
“You have to talk to a counselor and see, ‘OK, what kind of relationship do I have? Does it look or smell like debt?'” Chandrasekera continued.
“Because if you’re earning something like a reward, you could say that’s interest income that you’re getting,” he said. “So in these platforms, you kind of have to go one by one and see what kind of relationship you have with the platform.”
If the crypto lending platform meets the above criteria, a person can declare the initial value of the cryptocurrency (i.e. the cost basis) when it was first lent to the platform as a short-term capital loss.
Consider the case of a hypothetical crypto investor named Dan, who bought bitcoin for $10,000 in 2020. In 2022, Dan then loaned that same bitcoin, now worth $50,000, to a DeFi platform offering him 15% APY on his bitcoin. This platform then suffers an insolvency crisis and goes bankrupt, rendering Dan’s debt totally worthless. In this case, Chandrasekera says Dan could lay claim to his base of $10,000 as a non-commercial bad debt.
There are some capital loss limitations to keep in mind, namely that non-commercial bad debts are always considered a short-term capital loss.
In Dan’s case, therefore, if he has no other capital gains (from stocks or other crypto investments) lined up for that tax year, Chandrasekera says that out of the total of 10 $000 of non-commercial bad debts, he could deduct $3,000 this year and carry forward the remaining $7,000 to offset future capital gains.
As for the actual mechanisms for reporting non-commercial bad debts, the deduction is shown on Form 8949 as a short-term capital loss. This is where a user also deposits their crypto and stock gains and losses.
Chandrasekera notes that you must also attach a “Bad Debt Statement” to the return explaining the nature of this loss. Among other details, this should include “what efforts you made to collect the debt and why you decided the debt was worthless”, according to the tax authorities.
The IRS warns that if you recover or later collect some of the bad debt you deducted, you may need to include it in your gross income.
The fictitious sale rule
Taub says that these days – insofar as there are potential losses on real crypto holdings – he advises clients to take advantage of the fact that ““wash sell rules” don’t apply to crypto. He tells CNBC that investors should really watch their portfolios to consider “reaping losses” to offset capital gains on other investments.
Since the IRS classifies digital currencies like bitcoin as property, losses on crypto holdings are treated very differently from losses on stocks and mutual funds, according to Onramp Invest CEO Tyrone Ross. With crypto tokens, wash sale rules does not apply, which means you can sell your bitcoin and buy it back immediately, whereas with a stock you have to wait 30 days to buy it back.
This nuance in the tax code is huge for crypto holders in the United States, mainly because it paves the way for tax losses to be reaped.
“One thing savvy investors do is sell at a loss and buy back bitcoin at a lower price,” Chandrasekera explained. “You want to look as poor as possible.”
The more losses you can accumulate, the better it is for the long-term investor’s tax position.
“You can reap an unlimited number of losses and move them forward in an unlimited number of tax years,” Chandrasekera added.
Since the wash sale rule does not apply, crypto investors can reap their losses more aggressively than with stocks, as there is no built-in waiting period.
“I see people doing this monthly, weekly, quarterly, depending on their level of sophistication,” he said. “You can collect so many of these losses.”
The accumulation of these losses is how investors ultimately offset their future gains.
When an individual goes to liquidate their crypto stake, they can use those collected losses to reduce what they owe to the IRS through capital gains tax.
Quickly redeeming the crypto is another key part of the equation. If timed correctly, buying the dip allows investors to catch up, if the price of the digital coin rebounds.
Suppose a taxpayer buys bitcoin for $10,000 and resells it for $50,000. This person would face $40,000 in taxable capital gains. But if that same taxpayer had already reaped $40,000 in losses from previous crypto transactions, they would be able to offset the tax they owe.
This is a strategy that is spreading among CoinTracker users, according to Chandrasekera.
Still, he warned that thorough accounting is essential.
“Without detailed records of your transaction and your cost base, you cannot justify your calculations to the IRS,” he warned.
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