The phenomenal rise in Bitcoin’s value from 50 cents in 2011 to nearly $65,000 last November has resulted in the creation of many copycats. In 2022, it is believed that there is over 20,000 cryptocurrencies although only about 11,000 of them are actively traded. Last year, the rise in popularity of non-fungible tokens (NFTs) also resulted in a similar explosion in value and number.
Despite the promises made by many crypto and NFT promoters, the truth is that most of them will fail and end up worthless. A few of them probably had legitimate uses and business plans that just didn’t work out for one reason or another. But many of them were created with the intention of deceiving unsuspecting people.
These scams typically come in two forms. The first is known as pork butcher scam, where a scammer charms his victim with promises of quick riches to convince them to deposit money into a fake crypto account. The other is known as a carpet cover, where fraudulent developers create a new crypto token or NFT project, pump up the price and extract as much value from them as possible before they disappear. Unlike pig slaughter, which targets individuals, blanket schemes typically involve many victims because the promoters publicize their fraudulent project on chat groups and even on popular websites. These transactions have also been classified as Ponzi schemes, as these scammers use other investors’ money to pay either original investors or themselves.
These victims may be eligible for increased tax benefits. Last month I wrote one column for Bloomberg explains how investors who were victims of carpet pulling can claim a theft loss to reduce their taxable income. To summarize, victims of crypto or NFT fraud can claim an ordinary theft loss as an itemized deduction on their tax returns and possibly use the losses to offset income in prior and future years. Usually these losses are treated as capital losses that may not be useful to people who do not have capital gains to offset.
If victims can show that their cryptocurrency investments were actually Ponzi schemes, they may qualify for theft loss deductions using a safe harbor. To take advantage of this safe harbor, the principal of the investment scheme must be charged (but not convicted) in the United States of criminal fraud, theft or embezzlement, and the taxpayer must claim the theft loss in the year in which the criminal charges are filed. The losses claimed are limited to 95% of losses if the taxpayer does not pursue third party recovery or 75% of losses if they pursue third party recovery. The loss amount is further deducted by any amounts actually recovered and likely to be recovered in the future.
Consider it most crypto investors are young adults, and others may know a little about cryptocurrencies and how they work, victims may feel more comfortable choosing the safe haven. It can also increase their chances of getting the most tax benefits. On that note, they will do everything they can to make sure the main characters are charged with crimes.
In the biggest cases of crypto fraud, the main character(s) have been identified. For example, Do Kwon has been linked to the collapse of the cryptocurrency Luna and is wanted by South Korean prosecutorsthe OneCoin cryptocurrency has been branded a Ponzi schemeand its CEO has been charged with fraud in India.
The problem is that, in most cases, criminal charges are rare unless there are many victims or other compelling reasons to press charges. The other problem is that sometimes the main character cannot be easily identified, so it can take years before they are charged with a crime.
However, even if there is no charge, victims of crypto and NFT scams can still take a theft loss if they invested the money with the intention of making money.
Victims of crypto and NFT scams may be able to get enhanced tax benefits. While criminal charges against these fraudsters are rare, victims can put more pressure on prosecutors to investigate and charge the ringleaders so they can take advantage of the IRS safe harbor, which simplifies the loss reporting process. This could result in more arrests and prosecutions of fraudsters in the future.
Steven Chung is a tax attorney in Los Angeles, California. He helps people with basic tax planning and resolves tax disputes. He is also sympathetic to people with large student loans. He can be contacted via e-mail at email@example.comOr you can connect with him on Twitter (@stevenchung) and get connected to him LinkedIn,