Even if Your Crypto Lender Collapsed, You Still Owe the IRS

If you are a customer of a failed crypto lender such as Celsius Network, Voyager Digital VYGVQ +10.03%, or BlockFi, you may be in for an unexpected surprise this filing season.

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In spite of the bankruptcy proceedings engulfing their earnings, the investors are likely to still be liable for taxes on much of what they received in their accounts last year, regardless of whether they were locked up in bankruptcy proceedings.

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It is the tax code that is responsible for the problem. When income is earned, a great deal of it is taxed as soon as it is earned-and the bankruptcy process can take years to unfold before creditors are able to know what, exactly, they are going to recover.

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This past year, cryptocurrency investors were nearly inevitably affected by bankruptcy while earning interest on their cryptos. A few examples of Celsius Networks are Voyager Digital and Voyager Digital URI: 

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BlockFi all promised retail investors yields exceeding 10% on Bitcoin deposits and other token deposits. Investing in riskier trades or decentralized finance protocols was part of how they paid such high yields or re-lending the money to institutional investors.

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Despite securities regulators saying the products violated the law and did not disclose their risks, these platforms collected tens of billions of dollars in deposits. During the next few years, as crypto companies and investors imploded, the firms, one after another, halted customer withdrawals and sought bankruptcy protection.

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Whether cryptocurrency customers can recover any of their losses is still unclear, as bankruptcy proceedings are still going on.

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Before trying to claim a tax loss for FTX US's bankruptcy, customers will need to see how much of their funds they can recover.

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There is a possibility that bankruptcy cases may take years to resolve.

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However, even if the funds were still trapped in a bankruptcy estate, customers who received interest payments from any of those firms will still be required to pay income taxes on the funds this year, said Shehan Chandrasekera, a CoinTracker tax strategy expert.

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Due to IRS rules, earnings appear to be earned whenever they are paid, regardless of whether they ever leave the platform. In order for filers to recognize losses, bankruptcy cases must be finalized and investors need to know exactly how much they will recover from the bankruptcy.

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Since all these bankruptcy filings are still pending, it is difficult to do anything for tax purposes. Chandrasekera says that nothing has been finalized.

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In an email sent to customers, Gemini, the crypto exchange founded by the Winklevoss twins, informed them that they had asked the IRS for an extension of 30 days to receive 1099-MISC forms from their yield-paying product, Gemini Earn.

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Although Gemini Earn did not go bankrupt, it had placed customers in loans with Genesis Global, whose lending arm went bankrupt last month. There haven't been any withdrawals since November for Gemini's customers. According to Gemini, investors were unable to access their assets on the platform because of Genesis' bankruptcy case.

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Moreover, the firm insists on reporting income that is available for withdrawal at any point in 2022 "irrespective of whether customers withdraw it."

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A similar statement was provided by Voyager last year, but it added that “because your crypto claim has not yet been adjudicated, it is likely that you cannot claim a loss with respect to the cryptocurrency you deposited on Voyager since the bankruptcy has not yet been adjudicated”

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Depending on the number of assets returned to customers following the bankruptcies of various lending firms, Chandrasekera said they may be able to claim losses. In the event some filers don't get tax refunds for this year's income, they can amend their 2022 returns to get those refunds.

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It is important for investors to be prepared for an audit in the event that they claim those losses on future tax returns.

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"You might still get audited if the IRS discovers you didn't file a tax return correctly and actually lost your money," says Chandrasekera, who advises investors to hire a tax professional. There are only a few deductions like this in a year."