Recently a client of mine, who I will call John for privacy sake, painted himself into a corner and lost access to his cryptocurrency account which contained thousands of dollars in alt coins. He generated a code to encrypt his wallet and saved the code to Amazon Drive. Unfortunately, John’s Amazon drive synced over his password file, which was the only location the password was stored. My client tried everything to recover the password, including “brute force” hacking into his account, but calculated this would take 762,183,626 years to finally break the code!
To add salt to the wound, Uncle Sam will not allow you to deduct losses resulting from lost passwords. IRS Publication 547 states deductible losses must be the result of a casualty, which it defines as “an identifiable event that is sudden, unexpected, or unusual.” Some examples of events the IRS uses are car accidents, floods, earthquakes, and fires. Careful if you plan on starting a little fire to wipe out your unrecoverable password – the IRS thought of that too. Fires that are willfully set or that you pay someone else to set do not qualify for deductible losses.
Sad to say, my client would have been better off if his computer containing his password had been stolen. John could recover some funds from theft loss if he could show all of the following: (1) When you discovered that your property was missing, (2) that your property was stolen, (3) that you were the owner of the property, and (4) whether a claim for reimbursement exists for which there is a reasonable expectation of recovery.
Are there any other scenarios in which you can recover losses from getting your cryptocurrencies wiped out? Yes! The IRS will allow you to deduct your losses if your cryptocurrency exchange becomes insolvent or bankrupt. This is highly unlikely, but Mt. Gox has shown that nothing is impossible.
If you do have a loss to declare from any of the tragedies stated above, you would need to itemize these losses on Schedule A. In other words, if your losses combined with other itemized deductions are less than your standard deduction ($12,700 for married couples), then there would be no point in declaring these losses. You can claim these losses either as a casualty loss on Form 4684 and Schedule A, or as an ordinary loss on Schedule A.
Back to John. Needless to say, his funds will remain irrecoverable and lost in crypto space indefinitely. This was an expensive lesson for my client and one I am sure he will never forget! Three takeaways he learned and that would benefit us all: (1) store your password in a backup location, preferably physically written down somewhere, (2) change your program settings to always have a backup file available, and (3) use a password that you can remember, although preferably not “123456” or “password.”