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
[email protected].
Or
you
can
connect
with
him
on
Twitter
(@stevenchung)
and
connect
with
him
on LinkedIn.