A handful of crypto yield generating platforms, such as Celsius, Voyager Digital, Babel Finance, CoinFLEX are facing liquidity crunches and froze or limited withdrawals as a result of the recent crypto crash and liquidity crunch. There could very well be more.
Although the recovery efforts are underway and distressed firms are looking for paths forward, it is possible that some platforms may become insolvent, preventing customers from accessing their funds. Although this would be undoubtedly painful, there could be a small silver lining. Investors might be able to use an obscure tax deduction called Nonbusiness bad debt (§166(a)(d) to write off losses and get some tax relief.
Nonbusiness Bad Debt Deduction
A non-business bad debt is a loss from the total worthlessness of a debt you extended to another party. The highlighted terms are very important.
First, the debt must be totally worthless to be deductible under this provision. Generally speaking, a debt is totally uncollectible and therefore worthless after you have tried every reasonable way to collect on it and have been unsuccessful. It’s also deemed worthless if the borrower files for bankruptcy and the debt is discharged.
Second, you can only apply the nonbusiness bad debt deduction to debt instruments. This means loans in simple terms. This specific deduction can not be applied to non-debt instruments like stocks, commodities, coins, and tokens. (You may be able to deduct these losses under other IRS code sections depending on the facts & circumstances of each case)
Some clarity can come from looking into the terms and conditions of these platforms. For example, Celsius’s language makes clear that you have lent your coins to the platform to earn yield creating a debt instrument.
But again, the specific terminology matters, so be sure to read it carefully.
How Much You Can Deduct And When
As mentioned above, you can write off nonbusiness bad debts only when they are totally worthless. Since most platforms are actively or reportedly working on restructuring and obtaining credit lines to resume withdrawals, it is unlikely that most debts are totally uncollectible & worthless at the moment. A full recovery and/or a partial recovery of your funds may still be possible.
However, If your debt becomes totally worthless, you can deduct the initial value of it (basis).
For example, say John purchased 1 bitcoin (BTC) for $10,000 a few years ago. In 2022, he loans this BTC to platform X to earn a 5% yield. At the time he loans the BTC to X, it is worth $50,000. The platform goes bankrupt and John’s debt becomes totally worthless. Here, John can deduct $10,000 as a nonbusiness bad debt.
How To Report Nonbusiness Dad Debt Deductions
You can report a nonbusiness bad debt as a short-term capital loss on Form 8949 (Sales and Other Dispositions of Capital Assets), Part 1, line 1, and check box (C), Short-term transactions not reported to you on Form 1099-B.
Since this is a nonbusiness bad debt deduction, you will also have to attach some additional paperwork (a bad debt statement) to your tax return.
The bad debt statement must contain the following;
- a description of the debt, including the amount and the date it became due.
- the name of the debtor, and any business or family relationship between you and the debtor.
- the efforts you made to collect the debt.
- why you decide the debt was worthless.
Bad Debt Statement Example:
John Doe – Social Security Number: 123-45-6789
Description of Debt: 1 bitcoin
Debt Amount: $10,000 (Total amount owed)
Due Date: On Demand
Name of Debtor: Platform X
Relationship: Unrelated third party
Efforts made to collect this debt: Made several attempts (explain and attach logs) to withdraw funds but failed.
Why this debt was worthless: Company declared bankruptcy on dd/mm/yyyy. Therefore, $10,000 is totally uncollectible and therefore worthless.
Nonbusiness Bad Debt Tax Relief May Be Limited
Although the nonbusiness bad debt deduction is a useful provision to get some tax relief, the immediate tax benefit of the deduction may be limited in some cases. This is because this deduction is treated as a short-term capital loss and is subject to the $3,000 annual capital loss limitation.
Going with our example above, if John doesn’t have any other capital gains coming from stocks or crypto trading during 2022, out of the $10,000 total nonbusiness bad debt, he can only deduct $3,000 in 2022. He can carry forward the remaining $7,000 ($10,000 – $3,000) to offset future capital gains.
But there may be other options to lower your tax bill. If the rest of your portfolio is down, tax loss harvesting is another strategy you can follow to reduce your current and future tax bills. It involves selling your coins at a lower price than you paid for them, realizing losses for tax purposes and buying back the position within a reasonable period of time. These harvested losses can help you offset your capital gains generated from stocks and crypto in 2022. If you don’t have any capital gains this year, you can also carry forward these losses to future years to offset future income.
- Keep an eye on your frozen funds and determine when/if they become totally worthless.
- Consult with a tout tax adviser before claiming a nonbusiness bad debt deduction.
Editor’s Note: Nothing in this report should be considered financial advice.