A tax write-off is possible for bitcoins that end up on platforms like Celsius

Crypto lending platforms like Celsius, Anchor, and Voyager Digital became famous for offering almost unbelievable returns of up to 20% annually on customer deposits. Now, a significant portion of this crypto-money is trapped as the sharp drop in token prices forces platforms to temporarily suspend or limit withdrawals.

After its own solvency crisis, Celsius, which still advertises annual returns of up to 18.63% on its website, has held customer funds for more than three weeks and has yet to announce its next steps.

So who will be left holding the bag when these platforms go belly up?

Unlike the traditional banking system, which typically insures customer deposits, there are no formal consumer protections to protect users’ funds when things go wrong on decentralized financial platforms. “High risk, high reward” is the general motto of the DeFi ecosystem. For those who have lost their savings due to these crypto lending platforms, there is no way to recover the losses.

But Shehan Chandrasekera, a chartered accountant, tells CNBC that the U.S. tax code may offer some relief to these investors in the form of an obscure deduction.

“If your funds become completely worthless and irrecoverable, you may be eligible to write them off as a non-profit bad debt,” said Chandrasekera, lead tax strategist at CoinTracker.io, a digital currency tax software company that helps clients track their crypto to virtual wallet addresses and manage their tax obligations.

“It won’t cover all of your economic losses, but it will give you some tax relief because you can at least write off that initial investment that you made,” Chandrasekera.

“It is also considered useless if the borrower files for bankruptcy and the debt is discharged,” Chandrasekera the tweets thread explains detailing how submissions may claim a deduction.

Still, Taub says that even if a platform files for bankruptcy, the owners can still get something in bankruptcy court, so it’s still not a total loss. For example, Voyager Digital filed for Chapter 11 bankruptcy Tuesday night, but it’s unclear whether users will be able to recoup some of their losses through the process.

Determining whether the money you have given to a crypto platform is a loan is not always easy. For example, cryptocurrencies and stocks, which are considered non-debt instruments, are not subject to this write-off.

“In order to have a non-business problem debt, there must be an actual debtor-creditor relationship. So, to the extent that crypto was lent to the platform, the criteria is met,” said Taub, director of tax services at Berkowitz Pollack Brant, one of the largest public accounting firms in Florida.

Let’s take Celsius. Its terms state that any digital asset transferred to the platform constitutes a loan from the Celsius user.

However, not all platforms are so transparent in their terms. According to Chandrasekera, neither Voyager nor BlockFi accurately describe the user’s relationship with the platform.

That’s why CPAs are advising those affected by crypto platform suspensions to contact a financial advisor to see if their investments qualify.

“You need to talk to a counselor and see, ‘Okay, what’s my relationship? Does it look or smell like debt?” Chandrasekera continued.

“Because if you’re earning something like a reward, you can claim that it’s interest income that you’re getting,” he said. “So on those platforms, you have to go one by one and see what kind of relationship you have with the platform.”

If a crypto-lending platform meets the above criteria, a person can report the original value of the cryptocurrency (ie 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 $10,000 worth of Bitcoin in 2020. In 2022, Dan lent the same Bitcoin, now worth $50,000, to a DeFi platform, offering him 15% APY on his Bitcoin. That platform then suffers insolvency and goes upside down, rendering Dan’s debt completely worthless. In that case, says Chandrasekera, Dan will be able to claim his foundation $10,000 in bad debt.

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

So in Dan’s case, if he has no other capital gains (from stocks or other crypto investments) for this tax year, Chandrasekera says that of the $10,000 in total non-profit debt, he could deduct $3,000 this year and carry it forward balance of $7,000 to offset future capital gains.

As for the actual reporting mechanisms for non-commercial bad debt, the deduction is on Form 8949 as a short-term capital loss. This is where the user also stores their crypto and stock profits and losses.

Chandrasekera notes that you should also attach a “bad debt statement” to the return, which also explains the nature of that loss. Among other details that should include “the efforts you made to collect the debt and why you decided the debt was worthless.” according to the IRS.

Taub says that these days — to the extent that there are potential losses on actual crypto holdings — he advises clients to take advantage of the fact that “wash sale” rules don’t apply to crypto. He tells CNBC that investors should really monitor their portfolio to consider “harvesting losses” to offset capital gains from other investments.