Cryptocurrency represents a paradigm shift for money as we know it — how we save it, how we invest it, how we spend it.
Hailed as the disruptor of the global banking system, these decentralized networks are built around the concept that there should be no need to check in with a corporate entity to access your own money, thus offering its owners a sense of freedom. With that freedom, however, comes a newfound responsibility to keep your funds safe and secure since, unlike in a traditional banking environment, there is no one watching it for you.
Understanding Chain Transactions
In cryptocurrency, chain transactions are guarded by the use of public/private keys, cryptographic code, and incentive systems to ensure participants are not trying to game the system. Because there is no need for a third-party watchdog, such as a credit card company to verify legitimacy of a transaction or the identity of the end user, cryptocurrency chains streamline money transfers across borders making them faster than traditional banking networks. Due to the ability to remain anonymous while transacting in crypto, that freedom may come at the price of security.
Cyber criminals are always on the lookout for ways to find weaknesses they can exploit to their benefit. Cryptocurrencies are an attractive target to the criminal element for the same reasons it is attractive to the regular user: anonymity, speed, and decentralized accessibility. This begs the larger question: in the case that your crypto stash is stolen, what recourse has Internal Revenue Code (“the Code”) placed at your disposal? Is your stolen crypto tax deductible? Answer: The Code allows taxpayers to deduct losses sustained during the year and not compensated by insurance.
How the Internal Revenue Code Defines Theft
The Code defines a theft as the taking and removing of money or property with the intent to deprive the owner of it. The taking of property must be illegal under the laws of the state where it occurred and it must have been done with criminal intent. The Internal Revenue Service (“IRS”) has limited guidance when it comes to cryptocurrency, so a best faith effort to interpret and apply the current guidance is needed. In this case however, since cryptocurrency is treated as property by the IRS, a hacked wallet where coins are taken from the owner would certainly fit the definition of theft and a case could be made to that effect. Taking such a stance can be challenging if there are various jurisdictions involved as the definition of “theft” will ultimately need to be proven at the state level.
It’s important to note that the simple disappearance of money or property does not constitute a theft. If $100 bill falls out of my pocket and blows away, it isn’t stolen. However, an accidental loss or disappearance of property could qualify as a casualty loss if the facts and circumstances line up with the IRS’s definition. The IRS says a casualty loss needs to be linked to a sudden, unexpected, and unusual event. Let’s say a moving company that is helping the taxpayer relocate drops a heavy box on a cold wallet device used to “store” cryptocurrency and ultimately breaks it which in turn prevents the taxpayer from accessing the currency. This might be eligible for casualty loss treatment.
Personal Casualty Under the Tax Cuts and Jobs Act
Unfortunately, for tax years 2018 through 2025 as a result of the 2017 Tax Cuts and Jobs Act (“TCJA”), personal casualty and theft losses like the ones previously described are deductible only if the losses are attributable to a federally declared disaster. TCJA severely restricted which events may be considered as casualty and theft deductions. The only exception to the rule limiting the deduction for personal casualty and theft losses is if the taxpayer has personal casualty gains. The taxpayer may deduct personal casualty losses that aren’t attributable to a federally declared disaster to the extent of any personal casualty gains for the year.
However, it must be noted that if your cryptocurrency is used in a trade or business, then the theft might be fully deductible as the TCJA did not place stringent limitation in regards to business theft/casualty deductions.
Count on Friedman LLP
Our digital currency and blockchain practice group – among the industry leaders – works closely with our tax department and can help you with all your cryptocurrency questions. We can also assist in the unfortunate event that your currency “disappears.” Contact us now with any questions.