Billions in bitcoin trapped on lending platforms like Celsius may turn into a tax write-off for investors - CNBC

Crypto lending platforms like Celsius, Anchor, and Voyager Digital rose to prominence for offering almost unbelievable returns of up to 20% annually on customer deposits. Now much of that crypto cash is trapped, as plunging token prices force platforms to temporarily suspend or limit withdrawals.

In the wake of its own solvency crisis, Celsius — which is still advertising up to 18.63% annual yield on its website — has had customer funds on ice for more than three weeks and has yet to announce tangible guidance on next steps.

So who is going to be left holding the bag if these platforms go belly up?

Unlike the traditional banking system, which typically insures customer deposits, there aren't formal consumer protections in place to safeguard user funds when things go wrong on decentralized finance platforms. 'High risk, high reward' is the general motto of the DeFi ecosystem. For those who lost their life savings to these crypto lending platforms, there is little recourse for recouping their losses.

But Shehan Chandrasekera, a certified public accountant, tells CNBC the U.S. tax code may provide some relief to these investors by way of an obscure deduction.

"If your funds become totally worthless and irrecoverable, you may be eligible to write them off as a nonbusiness bad debt on your taxes," said Chandrasekera, lead tax strategist at CoinTracker.io, a digital currency tax software company that helps clients track their crypto across virtual wallet addresses and manage their tax obligations.

"It's not going to cover up your entire economic loss, but it's going to give you some type of tax benefit, because at least you get to write off that initial investment that you put in," Chandrasekera.

You can think of a nonbusiness bad debt as a type of loss resulting from a debt extended to another party, which has been rendered totally worthless and irrecoverable.

CPA Lewis Taub stresses that there must be a complete loss of all that was lent to the platform in order for the debt to be considered deductible. Partial losses don't count. The freezing of accounts, or limited withdrawals by crypto platforms, does not constitute a total loss.

At this stage, many of the crypto platforms are still calling the freezes "temporary" as they figure out how to shore up some liquidity, whether through restructuring or securing additional lines of credit.

Chandrasekera says that a debt falls into this category of "totally uncollectible" only after all attempts at collection have failed. So technically, none of the crypto funds on deposit at these platforms are completely worthless.

"It's also deemed worthless if the borrower files for bankruptcy and the debt is discharged," Chandrasekera explained in a tweet thread detailing how filers could claim the deduction.

However, Taub says that even if a platform declares bankruptcy, the holders may still get something in bankruptcy court, so it's still not a total loss. Voyager Digital, for example, filed for Chapter 11 bankruptcy Tuesday evening, but it's not yet clear whether users will be able to recover some of their losses through this process.

Determining whether the cash you have given to a crypto platform constitutes a loan isn't always straightforward. For example, crypto coins and stocks, both of which are considered to be nondebt instruments, do not qualify for this write-off.

"In order to have a nonbusiness bad debt, there needs to be an actual debtor-creditor relationship. So to the extent that crypto was loaned to a platform, that criteria is met," said Taub, who is the director of tax services at Berkowitz Pollack Brant, one of the largest public accounting firms in Florida. 

Take Celsius. It spells out in its terms and conditions that any digital asset transferred to the platform constitutes a loan from the user to Celsius.

Not all platforms are this transparent in their terms and conditions, however. Neither Voyager nor BlockFi clearly describe the relationship that the user has with the platform, according to Chandrasekera.

That's also why CPAs advise that those affected by crypto platform suspensions reach out to a financial advisor to see whether their investment qualifies.

"You have to talk to an advisor and see, 'OK, what kind of relationship do I have? Does it look or does it smell like debt?'" continued Chandrasekera.

"Because if you're earning something like a reward, you could argue that it's an interest income that you're getting," he said. "So in those platforms, you have to kind of go one by one and see what type of relationship you have with the platform."

Should the crypto lending platform meet the aforementioned criteria, an individual can report the initial value of the cryptocurrency (that is, the cost basis) when it was first lent to the platform as a short-term capital loss.

Let's take the case of a hypothetical crypto investor named Dan, who bought bitcoin for $10,000 in 2020. In 2022, Dan then lent that same bitcoin, now worth $50,000, to a DeFi platform offering him 15% APY on his bitcoin. This platform then suffers an insolvency crunch and goes belly up, rendering Dan's debt totally worthless. In that case, Chandrasekera says Dan would be able to claim his basis of $10,000 as a nonbusiness bad debt.

There are certain capital loss limitations to keep in mind, namely the fact that nonbusiness bad debt is always considered a short-term capital loss.

In the case of Dan, therefore, if he does not have any other capital gains (from stocks or other crypto investments) lined up for this tax year, Chandrasekera says that out of the $10,000 total nonbusiness bad debt, he could deduct $3,000 this year and carry forward the balance of $7,000 to offset future capital gains.

As for the actual mechanics of reporting nonbusiness bad debt, the deduction goes on Form 8949 as a short-term capital loss. That's where a user also files their crypto and stock gains and losses.

Chandrasekera notes that you have to attach a "bad debt statement" to the return explaining the nature of this loss, as well. Among other details, that must include "efforts you made to collect the debt and why you decided the debt was worthless," according to the IRS.

The IRS warns that if you later recover or collect some of the bad debt you've deducted, you might have to include it in your gross income.

Taub says that these days — to the extent that there are potential losses on actual holdings of crypto — he is advising clients to take advantage of the fact that "wash sale rules" do not apply to crypto. He tells CNBC that investors should really be watching their portfolio to consider "harvesting losses" to offset capital gains on other investments.

Because the IRS classifies digital currencies like bitcoin as property, losses on crypto holdings are treated much differently than losses on stocks and mutual funds, according to former Onramp Invest CEO Tyrone Ross. With crypto tokens, wash sale rules don't apply, meaning that you can sell your bitcoin and buy it right back, whereas with a stock, you would have to wait 30 days to buy it back.

This nuance in the tax code is huge for crypto holders in the U.S., primarily because it paves the way for tax-loss harvesting.

"One thing savvy investors do is sell at a loss and buy back bitcoin at a lower price," explained Chandrasekera. "You want to look as poor as possible."

The more losses you can rack up, the better it is for the investor's tax situation in the long run.

"You can harvest an unlimited amount of losses and carry them forward into an unlimited number of tax years," Chandrasekera added.

Because the wash sale rule doesn't apply, investors can harvest their crypto losses more aggressively than with stocks, because there's no baked-in waiting period.

"I see people doing this every month, every week, every quarter, depending on their sophistication," he said. "You can collect so many of these losses."

Accruing these losses is how investors ultimately offset their future gains.

When an individual goes to liquidate their crypto stake, they can use these collected losses to bring down what they owe to the IRS through the capital gains tax.

Quickly buying back the crypto is another key part of the equation. If timed correctly, buying the dip enables investors to catch the ride back up, if the price of the digital coin rebounds.

So let's say a taxpayer purchases one bitcoin for $10,000 and sells it for $50,000. This individual would face $40,000 of taxable capital gains. But if this same taxpayer had previously harvested $40,000 worth of losses on earlier crypto transactions, they'd be able to offset the tax they owe.

It's a strategy that is catching on among CoinTracker users, according to Chandrasekera.

Still, he cautioned that thorough bookkeeping is essential.

"Without detailed records of your transaction and cost basis, you cannot substantiate your calculations to the IRS," he warned.

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