For the many retail investors who had funds at FTX and were unable to withdraw them, the path to a tax deduction is not clear at this moment. Given the magnitude of this case, there is a possibility that the IRS may issue guidance relating to the case, or Congress might take action later this year. For this reason, many investors have filed an extension for their tax returns in the hopes of IRS issuing guidance but with the extension deadline around the corner, it seems unlikely that we will hear anything from the IRS on this issue any time soon.
Internal Revenue Code (IRC) §165(g) allows for a deduction “if any security which is a capital asset becomes worthless during the taxable year”. In that case, taxpayers can treat the security as sold on the last day of the taxable year for $0, and deduct their tax basis. There are two issues with attempting to use this code section to deduct the loss. First, digital assets or crypto assets are not within the definition of security as per IRC §165(g)(2). Second, the assets are not worthless. The amount the retail investors will be able to recover remains unknown. However, customers will be able to recover a portion of those funds when the dust settles. While this is better than suffering a total loss of funds, it complicates the tax situation as the amount of the loss may not be known for a while. To deduct a loss for tax purposes, you must know the amount of the loss.
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