I just talked to a client who had keep over $50,000 in Bitcoins safe on a private wallet. The private wallet is locked with special password. He thought he remembered the password.
He typed in it three times. Each time, he was told it was wrong. Then it permanently locked up never to be opened again. His Bitcoins are now in a cyber wasteland never to be used again. A tragic story, but not uncommon.
Can the loss be taken on the tax return?
The answer is that this type of crypto loss can be taken as an a deduction.
Many people have heard that as a result of the big tax law change in December 2017, casualty and theft losses can no longer be written off unless it is related to a federal disaster zone. Does this apply to a lost wallet? No it doesn’t.
Why is this? In the Internal Revenue Code section 165, deducting a loss is limited to three types of losses by individuals. The first type is a loss incurred in a trade or business. The second is a loss incurred in a transaction entered into for profit. The third type is all other types of losses including casualty and theft losses. The tax law change disallowed deducting the third type of loss. The client had purchased the Bitcoin with the intent of making a profit. Therefore, is was a type two loss and can be deducted from his taxes.
How does the deduction work?
The amount that can be deducted is the adjusted basis or the amount that he paid for the lost coins. Unfortunately, this is not the fair market value of the coins. In short, you can write off what you spent.
You should be prepared to prove that indeed you have lost the password to the wallet and that it is no longer accessible. This may be tricky. In case of audit, these proofs and the worthless wallet should be retain until the statute of limitations on the return expires.
Clinton Donnelly is an Enrolled Agent with a law degree. He solves tax problems for crypto traders. Click the green button on his website to schedule a consultation.