The Outcome of SBF’s Prosecution Could Determine how the IRS Treats your FTX Losses

Will your FTX losses be classified as capital losses or as “theft losses” involving a Ponzi scheme? You’ll probably win either way.

After the collapse of his cryptocurrency exchange, FTX founder Sam Bankman-Fried received official criminal charges, which is more than just a moral victory for the exchange’s roughly 1 million individual investors. While nothing has been finalized, it appears that these investors will be able to take a more favorable tax position as SBF’s fate unfolds.

Earlier this fall, it appeared that assets lost in the FTX collapse would be treated as a capital loss under US tax law for the tax year 2022. This capital loss can be offset by capital gains. However, after a year in which the crypto market as a whole took a beating, most investors will not have capital gains to offset in 2022.

Up to $3,000 per year, a capital loss can also be used to offset “ordinary income,” such as money earned from a business or job. The loss is carried forward indefinitely, but if your loss in the FTX collapse was significant, it may take some time to claim it all.

Many investors would benefit far more from claiming a theft-loss deduction, which can offset ordinary income without limit. Normally, claiming a theft loss is a difficult task that can draw the attention of the Internal Revenue Service. However, the tax code for theft loss includes a “safe harbor” provision for Ponzi schemes. Generally, if an investor can demonstrate a loss in a Ponzi scheme, the IRS will not require additional documentation.

Because investor funds were illegally diverted to Alameda Research, SBF’s hedge fund, the IRS is likely to label FTX a Ponzi scheme. To qualify for the safe harbor, FTX or its “lead figure” SBF must be charged with fraud that matches the following description in the tax guidance:

“A specified fraudulent arrangement is one in which a party (the lead figure) receives cash or property from investors; purports to earn income for the investors; reports income amounts to the investors that are partially or entirely fictitious; makes payments, if any, of purported income or principal to some investors from amounts invested in the fraudulent arrangement by other investors; and appropriates some or all of the investors’ cash or property.”

The SEC’s charges against SBF are aimed at equity investors rather than retail investors. However, the SEC specifically mentions “the undisclosed diversion of funds from FTX customers to Alameda Research.” While this isn’t an official green light for the safe harbor, it’s a lot closer than we might have expected in 2022.

A criminal complaint combined with a confession activates the Ponzi scheme safe harbor in addition to criminal charges. While he has been very vocal in the aftermath of the FTX collapse, SBF has made no indication that he intends to confess to anything.

Investors who lost money on FTX have until April 18, 2023 to file their individual tax returns. It appears very likely that the SEC will file additional charges against SBF or FTX, removing any doubt about the Ponzi scheme safe harbor.

The IRS may also weigh in on whether the existing charges are sufficient to trigger the safe harbor, and hopefully, 2022 will be the year to take advantage of it. The theft loss could be claimed in a subsequent year, but most FTX investors will be eager to recoup some of their losses by offsetting income on their taxes as soon as possible.