Throughout 2022, the crypto economy has been in the throes of a bear market, which has taken a heavy toll on investors, platforms and protocols. While investors have watched the value of their holdings drop, there has been an uptick in failures at the platform and protocol levels, which has added fuel to the fire of investment losses and caused many questions for taxpayers caught in the middle.

Let’s examine two of the larger events to occur this year: the Celsius Network bankruptcy and the failure of Terra and its cryptocurrency LUNA, and discuss the potential tax implications of each.

Phil Gaudiano is the co-founder and CFO of Polygon Advisory Group. This article is part of Tax Week.

Celsius was a crypto lending platform that advertised very high interest rates on various cryptocurrencies that its 1.7 million users transferred to the platform. At its peak, the company held almost $12 billion worth of customer deposits under management. Then, on June 12 of this year, facing a liquidity crisis, Celsius posted a memo online informing its users that all withdrawal, swap and transfer functionality would be temporarily paused. A month later, on July 13, the company filed for Chapter 11 bankruptcy protection.

For customers of Celsius, there are many questions related to the failure of the platform. One that we often hear in our tax practice is, “Can I deduct my Celsius losses?”

The deductibility of Celsius losses hinges on the concept of bad debt, which is outlined in Section 166 of the Internal Revenue Code and related regulations. Since most Celsius customers are individual investors, we will look specifically at Section 166(d), which deals with nonbusiness bad debts, defined as any debt not related to the taxpayer’s trade or business. Generally, a nonbusiness bad debt is recognized as a short-term capital loss on a taxpayer’s return.

Two requirements need to be met to recognize a loss from a nonbusiness bad debt on a tax return:

Under Regulation Section 1-1.66-1(c), a bona fide debt is based on “a valid and enforceable obligation to pay a fixed or determinable sum of money” at some point. The determinable sum of money involved here would be the value of crypto deposited into Celsius.

For the debt to be completely worthless, it must be considered wholly uncollectible. It is important to note that under the regulations there is no mechanism for partial deductibility of nonbusiness bad debts. Instead, the entire debt must be worthless to deduct the bad debt as a capital loss.

Many taxpayers believe that Celsius’ bankruptcy filing is grounds to consider its underlying debts worthless; however, Regulation Section 1.166-2(c) holds that bankruptcy only indicates the worthlessness of “at least part of” a debt. Remember from above that the debt must be completely worthless to recognize a capital loss, so the regulations are reasonably clear here that bankruptcy proceedings don’t guarantee complete worthlessness.

So, what is a person who has crypto locked inside Celsius to do? The short answer is to wait and see. Once bankruptcy proceedings are finalized, some or all of the funds owed by Celsius to its customers may be paid back. But until we know for certain how much, if any, will be returned to customers there is no allowable tax loss. The entire tax code revolves around realization events – the consummation of transactions that have an economic effect – which trigger recognition of income, deductions, gains and losses. In this situation, there has been no realization event yet. In short, nothing has happened from a tax perspective.

The Terra ecosystem was a decentralized finance (DeFi) project that provided high yields to investors. During 2022 the yields offered on staked deposits of its native stablecoin terraUSD (UST) were nearly 20% per year.

TerraUSD is an algorithmic stablecoin that used its sister cryptocurrency, LUNA, to maintain its peg to the U.S. dollar. In May, over $2 billion worth of terraUSD was unstaked and began to be liquidated. As a result, terraUSD lost its peg to the dollar. More LUNA was minted in an effort to reclaim the peg, thereby flooding the market with LUNA tokens and diluting the value of each LUNA token in circulation. In a matter of a few days, LUNA had gone from a market price of over $120 to less than 1 cent.

Many investors saw the value of their LUNA and UST holdings fall precipitously during the crash. While it is unlikely that LUNA and terraUSD will recover their values (both are currently trading more than 95% below all-time highs), there is some relief available to investors who choose to sell their holdings and recognize a capital loss.

As mentioned previously, realization events form the backbone of the Internal Revenue Code (IRC). IRC Section1222 discusses various types of capital gains and losses, all stemming from the “sale or exchange” of a capital asset. In short, in order for a capital loss to be recognized an investor must first sell the asset at a loss. Continuing to hold LUNA (now trading as LUNC) or UST precludes loss recognition because no sale has occurred. The silver lining here is that both UST and LUNC are still available to trade on many exchanges, so selling the assets at a loss is possible.

Celsius and Terra are not the only major failures we have seen. Numerous other platforms and protocols have succumbed to the bear market over the course of 2022. For taxpayers caught in the middle there is some relief available through deductible losses – as either bad debts or capital losses, depending on the situation – but not until there is some triggering event that causes realization of those losses. If you are a taxpayer with exposure to a failed crypto project, consult your tax adviser to determine the best course of action in your case.