Crypto customers looking to write-off FTX investments for taxes will need to wait

The fourth-largest cryptocurrency FTX filed for bankruptcy on Nov. 11, but already the process is snarled with uncertainty and infighting, signaling it will be a long, drawn-out procedure to unwind, restructure, and potentially liquidate Sam Bankman-Fried’s crypto empire.

FTX customers, unlike previous failed crypto firms, may be in a better position because the exchange’s terms of service allowed account holders retain right and title to their assets. 

“If you’re able to recover your assets from a platform, you really haven’t really lost anything, you’re able to withdraw them. It’s really a no-harm, no-foul situation. You just get your assets back and move somewhere else,” says Miles Fuller, head of government solutions at TaxBit, a cryptocurrency tax and accounting software company.

But with so much on the line—FTX owes its 50 biggest unsecured creditors some $3.1 billion—the biggest investors will likely challenge users’ right to simply withdraw their assets. That means it probably will take a ruling from a bankruptcy judge to determine how customer assets will be handled. And that takes time.

If customers get roped into the full bankruptcy process because their assets aren’t returned outright, that will trigger tax implications, Fuller adds.

“Any of this stuff will be probably the 2023 tax year or maybe even later, depending on how long the bankruptcy drags on,” Fuller says. “I can’t imagine anyone having answers in the next six weeks or eight weeks before the year is up.”

How an FTX tax write-off could work

For U.S. tax purposes, being able to claim a loss comes down to three main elements: amount, timing, and the character of loss, Fuller says. Generally speaking, when you’re engaged in investment activity, it usually falls in the for-profit bucket.

The amount of the loss is determined by your purchase price, rather than the fair market value of the asset. So if an FTX user bought $10,000 of Bitcoin, the valuation starts there. 

Then any recovery is factored in. If through bankruptcy proceedings you get back $2,000 of your initial investment, the loss would be tallied at $8,000. 

That brings up the second critical element: timing. Tax law says you can’t claim a loss until you know with reasonable certainty what your recovery might be, Fuller says.

“​​That means right now, you don’t have people in real time right now marking down losses,” he adds. “That means any FTX customer losses don’t really become concrete or finalized until there’s some reasonable assurances how much users may expect to get back,” Fuller says. Typically, however, before an FTX customer can file a tax loss, the bankruptcy proceedings need to be further along, with rulings on how various potential creditors and assets will be handled.

That brings up the last element for determining how a markdown is handled: the character, or nature, of the loss. There’s still a bit of a gray area when it comes to cryptocurrency losses due to bankruptcy, but Fuller says investments that disappear due to bankruptcy typically are treated as an “ordinary loss,” meaning they offset any income, not just capital gains income.

But the IRS hasn’t provided any guidance on how these losses should be classified, nor has there been any litigation rulings around it to clarify matters. The IRS could decide that even crypto losses in bankruptcy are considered “capital losses,” and therefore only offset capital gains income, but Fuller says that’s unlikely.

What FTX customers can do now 

Many FTX users are caught in a waiting game, but there are things they can do now to ease the pain of later filings. Customers should make sure they’re documenting what assets and deposits are on the FTX platforms. It’s even a good idea to get a digital or physical printout of your trading history. 

“You’re gonna have to file taxes based on the activity you did on these platforms, and if they sort of disappear into the ether of bankruptcy, you may not be able to get records so you could properly file taxes,” Fuller says. 

It’s also worth paying close attention to any information on the FTX bankruptcy itself and related cases. There’s already been a class-action lawsuit filed in Florida, for example, against Bankman-Fried and a collection of celebrities who endorsed FTX over the years, such as Tom Brady and comedian Larry David. The lawsuit alleges FTX ran a “fraudulent scheme” that the personalities involved engaged in deceptive practices that cost investors $11 billion.

“You want to be paying attention and advocating for yourself,” Fuller adds, “or seeking professional help if necessary.”

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