Most people in the web3 space have at some point, experienced a rug pull, scam, bankruptcy or a defunct project. While these experiences are unpleasant, there are things you can do to claim these on your tax burden.
There are two treatments when it comes to rugs, scams, hacks, and bankruptcies: 1) Capital Loss and 2) Abandonment Loss. The concept of a casualty or theft loss does not exist anymore as it was removed back with the 2017 tax cuts and Jobs Act or the Trump tax bill.
A capital loss requires us to realize it, or having an event where the initial investment is gone. This can be applied to bankruptcies, defaults, rugs, and scams, where there's no recoverability of the funds and they're not tangible or accessible. We generally mark this as a loss on the date of the event.
A great example of this is in the case of the Cream hack in 2021, one of the liquidity pools was hacked, liquidity was drained, the pool collapsed, and funds were gone. We elected to mark that as a loss for some of our clients as the funds are no longer there.
Similarly, in the case of Voyager, BlockFi, or any exchange when there's bankruptcy proceedings, we can discharge or write off that debt because it's non-recoverable at that point. If any amounts are realized, they would potentially be recognized as income when they are received.
The reason why we potentially claim a capital loss over the abandonment loss is that it is generally stronger and easier to substantiate. It gets reported on the 8949 (and Schedule D) and can be viewed as a “better loss” for reporting purposes as it requires a realization event.
The second loss is considered an abandoned loss (which is a little bit trickier). It's a stronger loss to substantiate but it requires you to say I am no longer accessing it or cannot access it. Basically, you’re walking away from it and leaving it behind. It’s a better loss than a capital loss as it allows you to offset against other ordinary income (business, wages, dividends, interest).
A great example of this is Terra Luna. A lot of people got hacked, LUNC, AUST, and USTC went to almost zero but it still has a very minimal value. You haven’t had a hack or complete loss of funds, but a loss of value. You could choose to destroy the seed phrase and access the wallet and abandon that asset. Alternatively, in the case of hacks, thefts, or rugs, you could abandon the right to pursue the funds and claim the loss as such.
It requires a separate filing Form 4797 to the IRS which requires you to document the nature of the abandonment event. You can then claim an ordinary loss against ordinary income.
The key difference in the losses is that capital losses get first applied against capital gains, and then up to $3K is deducted per year ($6K married) or applied against capital gains in perpetuity until it is exhausted. Ordinary losses can be applied against ordinary income such as wages, business income, or other types of ordinary income allowing you to realize the full benefit of the loss in the year it occurred.
We hope you find this helpful, this is a very brief rundown which we are happy to dive into deeper on a call. Please feel free to reach out and book a call with any questions you may have.