Final week, Do Kwon, a person who just a few years in the past was probably the most well-known names within the cryptocurrency world, pleaded responsible to 1 depend of conspiring to commit commodities fraud, securities fraud, and wire fraud and one depend of committing wire fraud in reference to fraudulent schemes. His actions induced a serious crypto crash in 2022 which vaporized $30 billion in wealth and for some created tax issues along with monetary loss.
Kwon and his firm Terraform Labs created two cryptocurrencies: Luna and UST. Luna was a typical cryptocurrency like Bitcoin. However UST was a stablecoin. Stablecoins are typically backed by authorized tender currencies just like the U.S. greenback which retains its worth steady.
However UST didn’t have a money reserve to peg its worth. As a substitute, its peg to the U.S. greenback was primarily based on an algorithm that encourages dealer arbitrage. For instance, if the worth of 1 UST turns into lower than $1, folks can purchase UST, convert it to Luna, after which promote that Luna for a revenue. Conversely, if the worth of 1 UST is bigger than $1, folks can purchase $1 price of Luna, convert it to UST, then promote the UST for a revenue. In concept, this adversarial relationship between the 2 cash have been supposed to maintain UST’s worth in verify.
Kwon additionally established the Anchor Protocol to incentive use of UST. Anchor was marketed as a financial savings platform the place folks would deposit their UST and obtain a assured 20% curiosity. At the moment, high-yield financial savings accounts provided at most 1%. The unusually excessive return fee attracted buyers, largely folks searching for different investments.
In Might 2022, a really giant UST commerce induced it to lose its peg and stability. As UST’s worth fell, extra Luna cash have been produced in an try and stabilize the worth. However as a substitute, the large manufacturing of the Luna coin devalued that as effectively. This resulted in a loss of life spiral of each currencies — now price pennies on the greenback.
Kwon and Terraform Labs have been hit with civil lawsuits and felony investigations in each the US and South Korea the place he was primarily based. In the course of the UST crash, Kwon was in Singapore claiming that he was engaged on restoring the peg. However later he fled the nation. He was lastly arrested in Montenegro the place he was caught utilizing a pretend Costa Rica passport to board a flight to Dubai.
portion of UST holders have been retail buyers. There are numerous tales of people that misplaced their life financial savings on UST. A few of these folks cashed out investments, offered appreciated belongings, and withdrew from their tax-deferred retirement accounts triggering taxable revenue.
Sadly, the IRS issued two items of steerage. The primary is Discover 2014-21 which acknowledged the fundamental tax guidelines for cryptocurrency transactions. It acknowledged that until somebody is within the commerce or enterprise of buying and selling cryptocurrencies, a taxpayer is just entitled to assert a capital acquire or loss.
The second steerage from the IRS was a chief counsel memorandum launched in 2023. This memorandum acknowledged that taxpayers can’t declare a worthlessness or abandonment deduction for cryptocurrencies. It is because each of those are miscellaneous itemized deductions and these deductions have been disallowed for the years 2018 to 2025 because of the Tax Cuts and Jobs Act.
Some taxpayers had ample capital positive aspects to offset their losses. However others offered enterprise belongings, withdrew from tax-deferred retirement accounts or took different actions that triggered strange revenue. In these circumstances, capital losses can solely offset $3,000 of strange revenue, with the rest to be carried ahead indefinitely. This created the bizarre state of affairs the place the taxpayer has to pay taxes on revenue she or he doesn’t have.
There have been some tax-planning choices to reduce the sting. Those that saved their Luna or UST cash may observe the steerage acknowledged on the IRS 2023 memorandum to assert both the abandonment loss or the worthlessness loss on January 1, 2026, which is when miscellaneous itemized deductions could be allowed as soon as once more. Sadly the Massive Stunning Invoice which not too long ago handed made the disallowance of the miscellaneous itemized deduction everlasting.
Some have accused Kwon of working a Ponzi scheme. Certainly there may be evidence that cash from retail buyers was used to pay earlier buyers. Most of them have been giant, institutional buyers who cashed out earlier than the crash. If so, then taxpayers can use the Ponzi scheme protected harbor defined in Revenue Procedure 2009-20, a ruling issued in response to the Madoff Ponzi scheme that yr. That is usually thought of a theft loss deduction.
There are two issues with utilizing this protected harbor. First, the taxpayers utilizing this process can declare as much as 95% of the losses not lined by insurance coverage. This isn’t a serious hurdle for most individuals as they are going to merely settle for the 5% loss. However the larger downside is that the IRS has introduced that Kwon engaged in a Ponzi scheme and should problem this deduction in an audit.
The opposite choice is to assert a normal theft loss deduction for the cash they misplaced. This may be thought of a theft loss in reference to the manufacturing of revenue. It is because the taxpayer had a revenue motive after they put their USTs into the Anchor Protocol. It will be important that it isn’t labeled as a private theft loss which may solely be claimed in the event that they reside in a federal or state catastrophe space. A taxpayer claiming a theft loss should show that the loss resulted from a taking of property that was unlawful beneath state regulation the place the theft occurred and was executed with particular intent to steal. Usually, particular intent to steal was laborious to show in funding circumstances.
So what does Kwon’s responsible plea imply? It may present he had the precise intent to steal making it simpler to assert the theft loss deduction. In court docket, Kwon said, “In 2021, I made false and deceptive statements about why UST regained its peg. What I did was flawed and I need to apologize for my conduct.”
Regardless of this growth, the IRS may nonetheless be reluctant to permit a theft loss deduction. Nevertheless, the IRS appears to acknowledge that on-line cryptocurrency scammers exist and taxpayers mustn’t have face opposed tax penalties along with their monetary ache. Final March, the IRS launched one other chief counsel memorandum which permits taxpayers who have been victims of phishing scams or pig-butchering scams to assert a theft loss deduction.
For individuals who misplaced cash on Luna or UST, they have been initially confronted with restricted tax reduction choices. However in mild of Kwon’s current responsible plea on fraud fees and the current chief counsel cemorandum by the IRS, taxpayers might be able to reap the benefits of a theft loss deduction.
Steven Chung is a tax legal professional in Los Angeles, California. He helps folks with primary tax planning and resolve tax disputes. He’s additionally sympathetic to folks with giant pupil loans. He might be reached by way of e-mail at [email protected]. Or you possibly can join with him on Twitter (@stevenchung) and join with him on LinkedIn.
