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Here’s what’s happening with BlockFi.
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Crypto lender BlockFi filed for voluntary Chapter 11 bankruptcy earlier this week.
The company has paused withdrawals and other platform actions as it stabilizes and restructures its business.
BlockFi users must still account for gains and/or losses on their 2022 taxes, but there are ways to reduce your tax bill.
New Jersey-based crypto lender BlockFi filed for voluntary Chapter 11 bankruptcy earlier this week. Prior to the announcement, the platform paused all activity as the FTX crypto exchange crash unfolded. With this filing, BlockFi has resumed the platform freeze, barring all of its users from making withdrawals and performing other activities.
On the retail side, the news hits those with exchange-held assets the hardest, as BlockFi’s bankruptcy proceedings and reorganization process will determine how much they’ll get back, if anything at all.
Here’s what the BlockFi bankruptcy means for current users, as well as its tax implications.
What happened to BlockFi?
BlockFi announced its bankruptcy filing on November 28, 2022, less than three weeks after the FTX collapse. The crypto lender had also paused platform activity before filing for bankruptcy, and activity remains paused.
BlockFi said its filing would give it a chance to stabilize its business and establish a reorganization plan that benefits both stakeholders and its clients. In addition, the company says it plans to work on recovering all obligations it’s owed. In a hearing on November 29, 2022, BlockFi’s lawyer, Joshua Sussberg, revealed that FTX and Alameda Research owe BlockFi more than $1 billion. However, BlockFi says it owes FTX.US $275 million in USD stablecoins.
Following its bankruptcy announcement, a series of BlockFi tweets on November 29 revealed it’s forming an Official Committee of Unsecured Creditors (which will mainly be comprised of its clients). Plus, it tweeted that the court (on an interim basis) will allow it to “redact the names, addresses, and contact information of individual and clients” from the list of its 50 largest creditors. BlockFi intends to submit this to the court.
The crypto lender says it’s requesting approval from the Court to restore withdrawal activities for those with BlockFi Wallet accounts. It currently has $256.9 million in cash, and the company believes this will be enough liquidity to handle certain operations as it restructures. BlockFi also asked users not to submit any deposits to the BlockFi Wallet or its interest accounts.
What will happen to your crypto?
If you’re a BlockFi user and you’ve stored all of your assets through an external, non-custodial crypto wallet, its bankruptcy filing and platform freeze shouldn’t affect your holdings. But the story is different for those with assets stored through the BlockFi Wallet.
“Users who stored their digital assets on BlockFi may never be refunded,” said David Kemmerer, co-founder and chief executive officer of CoinLedger. “Assets held with a bankrupt crypto lender are sold to compensate creditors – who are the priority in the compensation list.”
According to Kemmerer, the crypto space is largely unregulated, and there’s less intervention from entities like the US Securities and Exchange Commission (SEC) or Commodity Futures Trading Commission (CFTC). The Federal Reserve, he added, doesn’t keep money to bail out investors in such a situation. “So, the compensation of BlockFi’s investors remains at the mercy of BlockFi.”
Georgia Quinn, General Counsel of Anchorage Digital, believes coverage for crypto users could be stronger.
“Recent market events have highlighted the lack of critical consumer and bankruptcy protections around crypto exchange custody,” she said. “When crypto is held in custody on an exchange, client assets could be commingled with the exchange’s assets, blurring the lines of whose assets are whose and what assets are subject to creditor claims.”
Traditional financial exchanges, she added, aren’t allowed to take custody of user assets, meaning there is no legal precedent for this particular relationship with respect to an exchange.
How does this impact your taxes?
Although BlockFi shut down its interest accounts to new customers earlier in 2021 (later relaunching them as BlockFi Yield for accredited investors in early November 2022), existing customers could still earn rewards on the cryptocurrencies in their accounts.
“The bad news is that the interest earned by investors from BlockFi’s interest-bearing accounts is still taxable, despite investors being unable to access the funds,” said Kemmerer. The IRS, he added, treats cryptocurrencies as property — requiring investors to pay capital gains on the asset class.
However, the crypto assets of those who utilized the BlockFi Wallet are currently locked on the platform, and the activity freeze — along with the question of whether traders will receive their full balances — creates a hurdle when it comes to reporting gains or losses on IRS Form 8949.
Quick tip: There’s another option traders can utilize once platform activity resumes. According to Kemmerer, you can take advantage of the crypto bear market by netting “the losses from the cryptocurrencies kept in the interest-bearing accounts through tax-loss harvesting.”
With tax-loss harvesting, you can offset your capital gains (i.e., investments that have grown in value since you first purchased them) and lower the amount you owe in taxes by selling an investment that has suffered loss. By selling the investment (aka “realizing the loss”), you can lower your tax bill.
By selling the investment and replacing it with another security, you get the tax benefit while maintaining market exposure. And the wash-sale rule — a law that prevents investors from buying an investment similar to the one they sold within 30 days of the sale — doesn’t apply to cryptocurrencies.
How can investors store their crypto safely?
If you take the custodial route in storing your cryptocurrencies, you’ll generally be at the mercy of the exchange or platform you’ve chosen. And as we’ve seen with several crypto platforms (e.g., Mt. Gox and Celsius), users with assets held through the company will either receive payouts last — after creditors are paid off and financial obligations are settled — or nothing at all.
But you’ll have a few options for protecting your assets against bankruptcy. These include decentralized custody and DeFi wallets.
With decentralized custody, you — and only you — control the private keys to your crypto. This option allows you to either set up a hot wallet, or utilize a cold wallet. Hot wallets are online software that offer secure storage for digital assets. However, cold wallets, or hardware wallets, are external devices, meaning that they allow for offline storage.
DeFi wallets are also self-custodial, giving you total authority over your crypto wallet. Plus, another option is to set up both a non-custodial wallet and a custodial wallet, but this limits your overall control over your assets.
But none of the previously mentioned storage options are completely immune to things like theft or security breaches. Therefore, it’s important to thoroughly consider all of your options before choosing a particular method, and experts recommend never investing more than you can afford to lose. Plus, at this stage, you unfortunately won’t be able to transfer your existing BlockFi Wallet-held assets to another wallet due to the platform freeze.
Bottom line
If you stored your digital assets through the BlockFi Wallet, you’ll be restricted from making withdrawals or taking other actions until the company lifts its platform freeze. In addition, users are typically last to receive payouts in the event of crypto bankruptcy, since companies settle debts with creditors first.
Once platform activity resumes, you’ll still have to account for your gains and losses for the 2022 tax year, but you may be able to lower your tax bill by utilizing strategies like tax-loss harvesting.