Last week, Do Kwon, a man who a few years ago was one of the most famous names in the cryptocurrency world, pleaded guilty to one count of conspiring to commit commodities fraud, securities fraud, and wire fraud and one count of committing wire fraud in connection with fraudulent schemes. His actions caused a major crypto crash in 2022 which vaporized $30 billion in wealth and for some created tax problems in addition to financial loss.
Kwon and his company Terraform Labs created two cryptocurrencies: Luna and UST. Luna was a typical cryptocurrency like Bitcoin. But UST was a stablecoin. Stablecoins are generally backed by legal tender currencies like the U.S. dollar which keeps its value stable.
But UST did not have a cash reserve to peg its value. Instead, its peg to the U.S. dollar was based on an algorithm that encourages trader arbitrage. For example, if the value of one UST becomes less than $1, people can buy UST, convert it to Luna, and then sell that Luna for a profit. Conversely, if the value of one UST is greater than $1, people can buy $1 worth of Luna, convert it to UST, then sell the UST for a profit. In theory, this adversarial relationship between the two coins were supposed to keep UST’s value in check.
Kwon also established the Anchor Protocol to incentive use of UST. Anchor was advertised as a savings platform where people would deposit their UST and receive a guaranteed 20% interest. At that time, high-yield savings accounts offered at most 1%. The unusually high return rate attracted investors, mostly people looking for alternative investments.
In May 2022, a very large UST trade caused it to lose its peg and stability. As UST’s value fell, more Luna coins were produced in an attempt to stabilize the price. But instead, the massive production of the Luna coin devalued that as well. This resulted in a death spiral of both currencies — now worth pennies on the dollar.
Kwon and Terraform Labs were hit with civil lawsuits and criminal investigations in both the United States and South Korea where he was based. During the UST crash, Kwon was in Singapore claiming that he was working on restoring the peg. But later he fled the country. He was finally arrested in Montenegro where he was caught using a fake Costa Rica passport to board a flight to Dubai.
A good portion of UST holders were retail investors. There are many stories of people who lost their life savings on UST. Some of these people cashed out investments, sold appreciated assets, and withdrew from their tax-deferred retirement accounts triggering taxable income.
Unfortunately, the IRS issued two pieces of guidance. The first is Notice 2014-21 which stated the basic tax rules for cryptocurrency transactions. It stated that unless someone is in the trade or business of trading cryptocurrencies, a taxpayer is only entitled to claim a capital gain or loss.
The second guidance from the IRS was a chief counsel memorandum released in 2023. This memorandum stated that taxpayers cannot claim a worthlessness or abandonment deduction for cryptocurrencies. This is because both of these are miscellaneous itemized deductions and these deductions have been disallowed for the years 2018 to 2025 due to the Tax Cuts and Jobs Act.
Some taxpayers had sufficient capital gains to offset their losses. But others sold business assets, withdrew from tax-deferred retirement accounts or took other actions that triggered ordinary income. In these cases, capital losses can only offset $3,000 of ordinary income, with the remainder to be carried forward indefinitely. This created the unusual situation where the taxpayer has to pay taxes on income he or she does not have.
There were some tax-planning options to minimize the sting. Those who kept their Luna or UST coins could follow the guidance stated on the IRS 2023 memorandum to claim either the abandonment loss or the worthlessness loss on January 1, 2026, which is when miscellaneous itemized deductions would be allowed once again. Unfortunately the Big Beautiful Bill which recently passed made the disallowance of the miscellaneous itemized deduction permanent.
Some have accused Kwon of running a Ponzi scheme. Indeed there is evidence that money from retail investors was used to pay earlier investors. Most of them were large, institutional investors who cashed out before the crash. If this is the case, then taxpayers can use the Ponzi scheme safe harbor explained in Revenue Procedure 2009-20, a ruling issued in response to the Madoff Ponzi scheme that year. This is normally considered a theft loss deduction.
There are two problems with using this safe harbor. First, the taxpayers using this procedure can claim up to 95% of the losses not covered by insurance. This is not a major hurdle for most people as they will simply accept the 5% loss. But the bigger problem is that the IRS has announced that Kwon engaged in a Ponzi scheme and may challenge this deduction in an audit.
The other option is to claim a general theft loss deduction for the money they lost. This would be considered a theft loss in connection with the production of income. This is because the taxpayer had a profit motive when they put their USTs into the Anchor Protocol. It is important that it is not labeled as a personal theft loss which can only be claimed if they live in a federal or state disaster area. A taxpayer claiming a theft loss must prove that the loss resulted from a taking of property that was illegal under state law where the theft occurred and was done with specific intent to steal. Generally, specific intent to steal was hard to prove in investment cases.
So what does Kwon’s guilty plea mean? It could show he had the specific intent to steal making it easier to claim the theft loss deduction. In court, Kwon said, “In 2021, I made false and misleading statements about why UST regained its peg. What I did was wrong and I want to apologize for my conduct.”
Despite this development, the IRS could still be reluctant to allow a theft loss deduction. However, the IRS seems to recognize that online cryptocurrency scammers exist and taxpayers should not have face adverse tax consequences in addition to their financial pain. Last March, the IRS released another chief counsel memorandum which allows taxpayers who were victims of phishing scams or pig-butchering scams to claim a theft loss deduction.
For people who lost money on Luna or UST, they were initially faced with limited tax relief options. But in light of Kwon’s recent guilty plea on fraud charges and the recent chief counsel cemorandum by the IRS, taxpayers may be able to take advantage of a theft loss deduction.
Steven Chung is a tax attorney in Los Angeles, California. He helps people with basic tax planning and resolve tax disputes. He is also sympathetic to people with large student loans. He can be reached via email at stevenchungatl@gmail.com. Or you can connect with him on Twitter (@stevenchung) and connect with him on LinkedIn.
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