Last week, Do Kwon, once a prominent figure in the cryptocurrency sector, admitted guilt to charges of conspiring to commit commodities fraud, securities fraud, and wire fraud, as well as a separate count of wire fraud linked to fraudulent schemes. His actions were central to a significant crash in the crypto market in 2022, resulting in the loss of $30 billion in wealth and leaving many investors grappling with tax complications alongside financial losses.
### Background on Kwon and Terraform Labs
Kwon, along with his company Terraform Labs, developed two cryptocurrencies: Luna and UST. While Luna functioned similarly to Bitcoin as a cryptocurrency, UST was designed as a stablecoin. Stablecoins are typically pegged to traditional currencies, like the U.S. dollar, to maintain a consistent value. However, UST lacked a cash reserve to support its value; instead, it relied on an algorithm to encourage trader arbitrage. For instance, if UST’s value dipped below $1, investors could purchase UST, convert it to Luna, and then sell the Luna at a profit. Conversely, if UST’s value exceeded $1, they could buy $1 worth of Luna, convert it back to UST, and sell it for profit. This mechanism intended to stabilize UST’s price through its connection with Luna.
### The Collapse of UST and Luna
Kwon also initiated the Anchor Protocol to promote UST usage. This platform was marketed as a savings option where users could deposit their UST and receive a guaranteed interest rate of 20%, a stark contrast to the typical high-yield savings accounts that offered around 1%. This enticing return attracted many investors, particularly those seeking alternative investment opportunities. In May 2022, a significant trade involving UST led to a loss of its peg, resulting in instability. The decline of UST prompted the production of more Luna coins in an effort to stabilize the situation. However, this action further devalued Luna, creating a catastrophic downward spiral for both currencies, which ultimately became nearly worthless.
### Legal Consequences and Investor Impact
Following the crash, Kwon and Terraform Labs faced civil lawsuits and criminal investigations in both the U.S. and South Korea, where Kwon was based. During the turmoil, Kwon was in Singapore, asserting efforts to restore UST’s peg but subsequently fled the country. He was arrested in Montenegro while attempting to board a flight to Dubai with a counterfeit Costa Rican passport. Many UST holders were retail investors, with numerous reports of individuals losing their life savings. Some investors liquidated assets, withdrew from tax-deferred retirement accounts, and incurred taxable income as a result of these actions.
### IRS Guidance on Cryptocurrency Losses
In response to the fallout, the IRS issued two significant pieces of guidance. The first, Notice 2014-21, outlined the basic tax rules for cryptocurrency transactions, indicating that unless individuals were actively trading cryptocurrencies as a business, they could only report capital gains or losses. The second was a chief counsel memorandum released in 2023, which clarified that taxpayers could not claim a worthlessness or abandonment deduction for cryptocurrencies due to changes in tax law from the Tax Cuts and Jobs Act, which disallowed such deductions from 2018 to 2025. While some taxpayers had enough capital gains to counterbalance their losses, others faced ordinary income tax due to the liquidation of assets, with capital losses limited to offsetting only $3,000 of ordinary income, necessitating indefinite carryover for any excess.
### Future Tax Planning Options
Despite the challenges, some tax-planning strategies may help mitigate the impact. Investors retaining their Luna or UST coins could potentially claim an abandonment or worthlessness loss in 2026, aligning with when miscellaneous itemized deductions are expected to be permissible again. However, recent legislation has made the disallowance of such deductions permanent, complicating recovery efforts.
### Allegations of Fraudulent Activities
Kwon has faced accusations of operating a Ponzi scheme, with indications that funds from retail investors were utilized to pay off earlier investors, many of whom were large institutional players who exited before the market crash. Should this allegation hold true, victims could leverage the Ponzi scheme safe harbor established in Revenue Procedure 2009-20, which provides a theft loss deduction. However, taxpayers must navigate two challenges: the IRS allows claims for up to 95% of losses not covered by insurance, and there is a possibility that the IRS may contest these deductions during audits, given Kwon’s established fraudulent activities.
### Implications of Kwon’s Guilty Plea
Kwon’s guilty plea could suggest he possessed the intent to defraud, which might simplify the process for claiming a theft loss deduction. In his court statements, Kwon acknowledged that he made false claims regarding UST’s stability and expressed remorse for his actions. Despite this development, the IRS may still hesitate to approve theft loss deductions, although it has shown recognition of online scams and the importance of not penalizing victims with detrimental tax consequences.
### Conclusion
For those who suffered financial losses with Luna or UST, the landscape for tax relief options was initially limited. However, in light of Kwon’s recent guilty plea to fraud charges and the IRS’s latest memorandum, there may be new avenues for claiming a theft loss deduction for impacted taxpayers.
