Crypto investors had their funds frozen. Now they may have to pay taxes

Even though investors can't access their accounts with bankrupt crypto lender Celsius Networks, they still owe taxes on the interest income they earned from the accounts last year.

Roman Smolkin thought things couldn’t get any worse after his account with bankrupt crypto lender Celsius Network was frozen, trapping more than $200,000 of assets.

Then came the tax bill.

The 42-year-old software designer in Florida first started investing with Celsius in April 2021, enticed by the double-digit yields it offered for crypto holdings stored on the platform. He even took out a home equity line of credit for $125,000 and put it all in Celsius. When the lender halted withdrawals in June, Smolkin went through a range of emotions — anger, frustration and then resignation that the money was gone.

The arrival of a 1099 tax form renewed the pain. Despite not being able to access his funds, Smolkin still owes income taxes on the $8,000 in interest he made in 2022, according to the form.

“I’m honestly freaking out,” he said. “It’s beyond frustrating — I lost the entire thing that earned the interest to begin with.”

Interest earned on bank accounts, certificates of deposit and corporate bonds is subject to income tax in the year it’s generated, according to the Internal Revenue Service. Typically, that’s a fairly straightforward process: Banks and other institutions send out 1099 forms listing the taxpayer’s interest income, which is then used when determining overall obligations for tax season.

But in a quirk of last year’s crypto collapse, investors are now receiving tax bills for money locked up on platforms like Celsius and Voyager Digital, which have frozen customer withdrawals as they undergo bankruptcy proceedings.

It could hardly come at a worse time for crypto investors. Not only have digital asset prices plunged in the wake of FTX’s collapse, but inflation, high housing costs and rising interest rates are also making it more difficult for everyday people to afford regular expenses — let alone taxes on investments they’ve likely lost.

The IRS said it was aware of the issue, but declined to comment.

FURTHER BLOW

When taxpayers complete their federal income tax returns — due this year on April 18 — they’re obligated to state all income for the year, which is then taxed at rates from 10% to 37%, depending on their income bracket. In addition, some people will pay capital gains taxes on profits made when an investment is sold.

Given the terrible performance of digital assets in 2022, capital gains are unlikely to be a problem for many crypto investors, but interest generated through crypto platforms’ lending arms could be. That interest was often far higher than what’s offered by traditional financial institutions — Celsius paid customers as much as 18% annually for storing coins on the platform.

Although all income is technically taxable regardless of whether you receive a 1099 form, getting one of those forms means the IRS is aware of it, making it even more important to report it accurately, said Adam Markowitz, a tax adviser at Luminary Tax Advisors in Orlando, Florida.

Markowitz can relate on a personal level. He also has thousands of dollars worth of crypto holdings locked up in Celsius and received a 1099 form for his interest earned, which he found surprising given the company is currently mired in bankruptcy proceedings.

He’s had clients ask if locked-up crypto holdings can count as capital losses. According to the IRS, if capital losses exceed capital gains, taxpayers can write off as much as $3,000 from their income each year. But since the companies currently holding the funds are in the middle of bankruptcy dealings, Markowitz believes losses can’t be counted yet.

HOLDINGS IN LIMBO

For Doug Stringer, the arrival of a 1099 form hit him while he was already down.

The 63-year-old, who works in private equity in San Antonio, has about $2.8 million worth of digital assets stuck on Celsius. At the peak, the value of his holdings reached almost $10 million. Now, asset prices have plunged, his funds are trapped and he just received a 1099 for interest income of about $67,000.

Stringer doesn’t know when he’ll retire now, but it’s not anytime soon.

“I put all my eggs in one basket,” he said. “And I’m wiped out.”

There’s a chance that those who lost money could one day claim a theft loss deduction, according to William Stromsem, who teaches accounting at the George Washington University School of Business. But that would require some kind of fraud conviction for those running the various crypto platforms.

Another possibility is that investors could claim crypto holdings as worthless securities, which would allow them to be considered capital losses, said Lisa Greene-Lewis, a tax expert at TurboTax. But that won’t be a possibility until bankruptcy proceedings are finished, so the best move is to report the interest income this year as stated on the 1099 form.

Kurt Mire in Houston recently received a 1099 from Celsius listing the $2,700 in interest he earned last year, despite having about $90,000 worth of crypto locked up. He also has about $250,000 trapped in his Voyager account, but hasn’t gotten a tax form from them yet.

The 62-year-old engineering consultant is hoping to one day claim it as a loss, but is getting frustrated by the long bankruptcy process.

“You lose all your money and then they send you a tax bill,” Mire said. “And there’s nothing you can do.”