Scams like “pig butchering,” fake investments, NFT fraud, and romance fraud using cryptocurrency are how billions of dollars get stolen every year from people. Once the immediate loss is felt by an individual victim, then comes the follow-up issue can this type of loss be deducted as a tax deduction? There is no clear answer on this and a tax deduction can be lost if the rules are not closely followed. This article will discuss the different tax treatments available for fraud losses due to investment scams involving cryptocurrency, what it takes to have good documentation for your body of evidence when it comes to backing up your claim if you were to go to an auditor to appeal the deduction, and how good forensic intelligence helps determine the final outcome after the victim.
The Tax Landscape After a Crypto Scam
Prior to 2017, theft losses (including losses from fraud) were deductible on Schedule A as miscellaneous deductions. The TCJA made sweeping changes to these deductions! Now, under current Tax Law, personal casualty theft loss deductions become suspended until 2025. The only exception is if the losses occur due to a federally declared disaster.
Therefore, the situation of a victim of cryptocurrency fraud here gets much more complicated than simply denied!
Three Potential Avenues for Tax Relief
- Theft Loss Deduction Under Certain Circumstances
Most personal theft deductions are no longer available due to the TCJA; however, losses related to investment fraud can still be deducted as investment theft. IRC §165(c)(2) allows a deduction for loss when the loss was from a transaction or series of transactions made with the expectation of profit. Because most people that were victims of pig butchering and Ponzi-style schemes were making their investment with the intent to make money, they can deduct the loss as an investment theft, not as a personal theft.
The IRS has addressed this issue through Revenue Ruling 2009-9 and Rev. Proc. 2009-20. The IRS created a safe-harbor framework for crime victims who have suffered losses due to fraudulent investment schemes (the framework was created for the Madoff Ponzi scheme, but represents the same type of fraud associated with cryptocurrency). Under this safe-harbor provision, qualifying victims can take deductions of either 95% or 75% of their net loss (depending on if they are pursuing third-party recoveries), without itemizing each asset that was stolen.
Some of the qualifying criteria under Rev. Proc 2009-20 include:
- The arrangement was confirmed to be a criminal fraud or Ponzi scheme,
- A criminal claim was filed for the arrangement through state or federal agencies,
- The victim invested with the expectation of making a profit and not for personal use.
- Capital Loss Treatment
The loss of Cryptocurrency purchased (via fraud) may be treated as a capital loss by some practitioners because it was sent from a wallet that disappeared (scam) rather than an irrelevant investment scheme. A capital loss offsets capital gains, or net capital losses can offset $3,000 of ordinary income each year and can carry forward.
How you characterize the loss will be a matter of fact, and it will depend on the structure of the scheme and the way money flowed in to and subsequently out of the scheme. A forensic reconstruction of the transaction flow will be necessary to substantiate either characterization.
- No Deduction – But Documentation Still Matters
No current deduction will be available if all other factors apply or if the above-mentioned requirements are satisfied. If you maintain a documented record of the loss, you will be able to utilize that same record as a future tax item should the legal or regulatory environment change and it can also be used as a defense in an IRS audit regarding use of those funds as unreported income.
The Role of Forensic Documentation
The IRS will not accept a victim’s story or taking pictures of their account in the event of an asset loss. What the IRS needs for proof of the theft loss is substantiation and in the case with crypto, in order to substantiate the claim are results from blockchain intelligence services.
In order to have a credible tax claim for a fraudulent crypto asset, there are a few things that you’ll need to provide.
Proof of Ownership and Basis – You need to prove to the IRS that you owned the asset that was taken from you and how much you paid for that asset. You can do this by providing the IRS with records from the exchange, addresses of the crypto wallets and transaction hash that demonstrate where you purchased the crypto asset.
Evidence That A Theft Has Occurred – This isn’t going to be self-evident, the IRS is able to determine whether an investment failed or if there has been a theft. Therefore, it will be necessary for you to provide proof to the IRS that there was intentional misrepresentation involved in the scheme, preferably in the form of a referral to law enforcement, a formal fraud report and/or a forensics report proving the fraud from the start.
Chain Of Custody Proof – A blockchain forensics company can provide an asset trail that will demonstrate how the asset went from your wallet to the next point of location, whether it was through mixing facilities, exchange transactions or conversion into dollars. This will provide your claim with support documentation to assist law enforcement with locating/returning your stolen money, as well as assist in the prosecution of the suspect.
Valuation Of Lost Asset – Due to the volatility of cryptocurrency, it is important to provide the last known fair market value on the date of theft as opposed to the amount you paid. You must provide the IRS with a documented valuation of the asset, along with the Blockchain timestamps, to prove this point.
If you do not provide the above documentation, even if you have a valid claim, it is very likely you will be denied on audit.
What “Discovery” Means for Your Deduction Timing
According to IRC §165, an individual who suffers a theft loss can take a deduction for the year that the loss is discovered, not for the year when the actual theft occurred. In crypto fraud cases, “discovery” may happen slowly – e.g., when a platform ceases to allow withdrawals, when all communication with the platform disappears, or when media reports about a fraudulent scheme are published. The IRS holds that the year of discovery is determined to be the earliest year in which a person would reasonably believe he/she had been the victim of a theft. If a person had continued to believe that he/she might receive the stolen property back such as if a platform indicates it was “processing” the victim’s withdrawal for an extended period the person has deferred his/her discovery year.
This is important because the time limit for filing an amended return is generally three years from the due date for filing. Victims who had losses in prior years may have a timeframe available to them in which to submit an amended return only when their discovery year falls within that timeframe. A victim should obtain an attorney or CPA who specializes in fraud loss claims to help determine his/her applicable work history.
State Tax Considerations
The Federal Tax Laws only represent half of the full picture. Many states chose not to adopt the TCJA’s prohibition for theft losses. Therefore, a theft loss that is not allowable as a deduction on your Federal tax return may still be allowable in your state, if your state has adopted its own theft loss reporting rules. For example, California, New York, New Jersey, and a few other states that have high state income tax rates will generally have much more specific rules related to theft loss than the federal government. As such, if you are a resident of one of these states which has its own theft loss deduction, then the value of proper forensic documentation and obtaining the assistance of a qualified tax professional will be materially enhanced.
Recovery Efforts and the 75% Safe Harbor Rule
Key aspect: If there is a reasonable potential of recovering amount (via civil suit, insurance or law enforcement asset seizure), the deductible loss will be based on 75% of the actual qualified loss instead of 95% (per Rev. Proc. 2009-20). The IRS believes that part of the loss may eventually be recaptured so the loss and resulting deduction should only reflect what is realistically net of the recovery potential there is.
While this may be a loss for some, it is a gain over the long-term to pursue recovery. A victim who tries to aggressively recover (file complaint with FBI, contract with forensic intelligence firms, hire an attorney), will see a reduction in immediate deduction under safe harbor rule; however, if a victim successfully recovers, he/she will have different taxable treatment for any amount recovered based upon any deduction taken previously.
Lionsgate Intelligence Network works with tax counsel and law enforcement to develop the necessary forensic documentation to support both civil and criminal recovery, and meet the tax professional documentation requirement for claiming a theft loss deduction.
Practical Steps for Crypto Scam Victims
If you have fallen victim of a cryptocurrency scam, no matter what steps you would like to take to pursue recovery of losses, in addition to your first steps, follow these guidelines:
File a report with the FBI’s Internet Crime Complaint Center (IC3), the Federal Trade Commission (FTC), and your state Attorney General immediately. If you wish to claim the loss as a tax deduction, it is necessary that you provide a police report regarding the theft.
Do not delete any records related to the scam including: messages, emails, platform screenshots, and a history of your wallet transactions. These will provide the basis of evidence when filing your claim.
Contact a blockchain forensics firm to collect the primary administrative documentation necessary to prove theft and trace your funds. Once you get your forensics report, it should include proof of theft, where your funds went after they were stolen, and the information needed by your tax advisor.
Consult with a tax professional who has experience working with tax deductions for losses resulting from scams. Not all CPAs and financial advisors are familiar with IRC sec. 165(c)(2), Rev. Proc. 2009-20, and the documentation requirements for substantiating a cryptocurrency theft loss, so you may need to check references to find an advisor that is competent in this area.
Do not contact individuals who you think are innocent but have information in relation to the recovery of your lost funds. If you do so, you may fall victim of another recovery scam where the perpetrator calls you using an alias of a government agency or recovery service and demands payment of an upfront fee. No legitimate forensic or recovery company will ever make unsolicited and random calls to potential victims nor will they ever charge for their services.
LGN’s Role in Victim Documentation
As of October 2023, Lionsgate Intelligence Network is good at investigating fraud through transactions made on the blockchain. Since 2022, they have routinely investigated and completed an analysis of over 21,000 cases of blockchain fraud. Each month they have identified and analyzed over $1.5 billion worth of fraudulent transaction activity involving blockchain networks. These reports can also be used for civil asset recovery and tax substantiation in addition to law enforcement agencies.
The forensic report generated from the case file associated with your case will document the various methods which were used to create the forensic chain of possession of the funds stolen from you, the wallets and wallet clusters that received those funds, as well as the various properties and resources that were used to identify the wallets and receiving entities through the proprietary database they have developed for this purpose. They will also provide the timestamped average value of each of the transactions when you would produce the same information to provide your tax attorney with the same type of information they would use to support your deduction for a theft loss.
Lionsgate works with the FBI, IRS Criminal Investigation, Department of Homeland Security (via HSI), and Europol to prepare its reports to meet their evidentiary standards. The rigorous approach to documenting the investigative process that Lionsgate takes provides the same type of credibility for its documentation as would be required in the tax context when filing your tax returns.
A Note on Future Legislation
The suspension of personal theft loss deductions imposed by the TCJA is set to end in 2025, which can open up broader deductibility options for victims of individual fraud starting in 2026, but this requires action from Congress. People who have lost money from fraud in 2024 or 2025 should closely follow developments regarding this issue, as they may be able to claim deductions that can only be accrued after 2025.
As the legislative landscape evolves, the importance of correct documentation remains unchanged. No one is able to claim a deduction without having proper documentation.
Conclusion
Financial crimes can be committed through different types of instruments, such as real estate or stocks. The IRS provides avenues for relief to someone who has been defrauded as a result of their investment. Accessing such relief will require forensic evidence, just as law enforcement would require that same forensic evidence to prove the crime.
The question for someone who has experienced a loss due to cryptocurrency fraud is not whether to file documentation for loss; it is whether you are working with the appropriate professionals to be able to do so.
Lionsgate Intelligence Network is a blockchain forensics and financial crime intelligence firm. We do not provide tax or legal advice. Victims should consult a qualified tax attorney or CPA regarding their specific situation. For forensic intelligence services, contact us at www.lionsgate-hybrid.matat.io.
