Finding Your Way to Tax Relief After Cryptocurrency Fraud: A U.S. Victim's Essential Guide

The rise of cryptocurrency and cyber financial fraud has left many individuals facing significant financial losses, sometimes reaching millions of dollars. Scams, such as "pig-butchering" schemes, involve fraudsters building trust with victims before ultimately stealing their money. As a result, many victims find themselves burdened with debt and tax penalties, further compounding the trauma of their financial loss and negatively impacting their quality of life. 

Navigating the aftermath of financial fraud can be overwhelming, particularly when it comes to understanding tax obligations and options for relief. This guide aims to provide victims with clear information and practical steps to help them regain control of their financial situation. 

Federal Tax Deduction

Capital Losses

If you lost money by transferring cryptocurrency to a fraudster, you might be able to claim a capital loss on your taxes. For example, if you bought Bitcoin for $50,000 and then transferred it to a fraudster who gave you nothing in return, you can count that $50,000 as a loss. You can use these losses to lower your taxes by offsetting any capital gains you may have or reducing up to $3,000 of your income each year and carry the rest of the losses forward to offset your future capital gains or continuing deduct $3,000 each year in the future years until the losses are exhausted. It's crucial to keep all records of your interactions with the fraudster to support your claim. 

Theft Loss

The Tax Cuts and Jobs Act (TCJA) made it harder to claim theft losses on personal items until 2026, but you can still make claims if the theft involves investment activities under Internal Revenue Code §165(c)(2). To qualify for these deductions, you need to show that:

- You intended to invest and earn a profit, not just use the money for personal reasons.

- The theft was illegal according to local laws.

- The money went directly to the fraudster.

- You have no realistic chance of recovering your stolen funds through legal means.

If your claim is successful, you could potentially deduct the entire amount you lost from your income, which could significantly reduce your tax bill.

Ponzi Scheme Parallels & Safe Harbor Options

Even though scams like pig-butchering are different from traditional Ponzi schemes, the IRS's Mark-to-Market Loss Safe Harbor (Rev. Proc. 2009-20) might still apply. For those who haven't recovered their investments, there may be a safe harbor rule allowing you to deduct up to 95% of your unreturned investment if you're trying to recover your money, or 75% if you aren't pursuing recovery. You need to show that the fraudster was in control of the investment and falsely represented gains.

Keeping Your Records Straight

To claim your losses, it's crucial to keep thorough records, including:

- Transaction details that show how your funds were sent.

- Screenshots of the fraudulent platform showing fake account balances.

- Communications with the fraudsters about your supposed profits.

- Reports from law enforcement about the fraud.

- You may need to submit a sworn statement explaining how the fraud occurred. 

There's a three-year time limit for claiming these losses, so it's crucial to seek expert help soon after discovering the fraud.

State-Specific Rules

While the federal government has set restrictions on theft loss deductions until 2026, some states have their own rules. For example:

- California allows deductions for personal theft losses over $500, though certain income thresholds apply.

- New York permits deductions for business-related theft losses without federal limitations.

- Texas has no state income tax, which simplifies things.

Check your state's guidelines, as they may require more documentation than federal rules.

Recent Developments

Starting in 2025, the IRS will have clearer rules for handling cryptocurrency losses. They will require proof from experts that the tokens are worthless and may also consider situations where exchanges have collapsed, like the FTX failure, for deductions under Section 165(g).

Recommendations for Victims of Fraud

Immediate Steps to Take:

1. Report the Incident: File reports with the Internet Crime Complaint Center (IC3) and your local police.

2. Keep Everything: Save all digital evidence related to the fraud, including emails, messages, and transaction records.

3. Get Expert Help: Consult forensic experts who can help verify your documentation and validate your losses.

4. Plan for an Audit: It's crucial to understand that to support a deduction, you must provide proof that a crime occurred.

Tax Considerations:

1. Understand Your Losses: Categorize your losses for tax purposes, whether as capital losses or theft losses. This could help reduce your tax burden.

2. Check State Deductions: Different states may have specific rules regarding deductions, so it's important to find out what applies to your situation.

3. Stay Informed: Keep an eye on new laws that might affect how you claim your losses. For instance, Proposed Bill HR 3684 expands theft loss provisions.

Seek Professional Help:

1. Tax Expert: Look for a tax specialist who is knowledgeable about the latest IRS guidelines related to theft losses.

2. Fraud Specialists: Engage fraud examiners familiar with the specific type of fraud you experienced. Your tax preparer, CPA, or tax attorney cannot act as expert witnesses for your fraud case; they are responsible only for accurately completing your tax forms.

Support from Digital Defenders Group

Recently, there has been an increase in tax audits targeting victims who have claimed deductions for Ponzi schemes and theft losses. The tax codes clearly state: "a loss from criminal fraud or embezzlement in a transaction entered into for profit, a theft loss, or a capital loss." To support a deduction, you must provide evidence that a crime occurred. This requires either an indictment or a report that is acceptable to the tax court and confirms that fraud took place. It’s important to note that merely reporting to law enforcement or other authorities does not establish you as a bona fide victim of fraud.

How Do You Prove Fraud? 

1. Participate in a Court Case: Whether criminal or civil, you will need to gather the same evidence that the IRS and tax court require to prove your case and establish that the fraud took place.

2. Obtain an Expert Fraud Analysis Report: This report can serve as expert evidence of the fraud. Note that a cryptocurrency trace report alone is not sufficient. For the report to be effective, the victim must promptly provide all relevant evidence and truthfully disclose all details related to the fraud, as the report is based on the information supplied by the victim.

It is vital to understand that your tax preparer, CPA, or tax lawyer who assisted you with your return is not obligated to support you during an IRS audit. The burden of proof lies solely with the taxpayer. For example, similar to receiving a bill for follow-up care after surgery, the fees you paid for tax preparation only cover the accurate completion of tax forms. An audit is a separate issue; no CPA or tax lawyer can assist without additional charges. Most importantly, a lawyer or CPA cannot provide a fraud report; you will need to hire an external expert for that, which will incur additional costs. The expert report must be convincing enough to hold up in tax court against the IRS.

To assist victims, the Digital Defenders Group has experienced tax experts who specialize in tax claims related to cryptocurrency and financial fraud, providing assistance at a low cost. We are committed to helping victims seek justice through effective legal claims and restitution avenues that can demonstrate the occurrence of fraud and facilitate financial recovery. Our team is equipped with specialists who can deliver expert fraud reports, if needed, for victims who are keen to pursue justice. 

Embracing the Path to Recovery

Dealing with financial fraud can profoundly impact your finances and emotional well-being. However, by taking proactive steps and seeking support, you can begin to alleviate some of your burdens. Documenting your losses, understanding tax implications, and consulting with professionals can help transform this distressing experience into a pathway toward financial healing. Remember, recovery is a journey that requires resilience and creativity. 

If you have been a victim of cryptocurrency crime or financial cybercrime, you're not alone in this fight. The Digital Defenders Group (DDG) is a nonprofit organization based in the U.S. that assists individuals who have suffered from these crimes and do not have the resources to seek justice on their own. We offer a range of free services, including tracing and investigation, fraud evidence evaluation, tax claim support, legal assistance, and more. To seek help, please visit https://www.digitaldefendersgroup.org/contact, complete the form in detail, and specify the type of assistance you need. It is crucial to provide accurate information about your case in order to receive the proper support.