Introduction — Why crypto recoveries create special tax and reporting questions
Cryptocurrency recoveries in bankruptcy pose three overlapping issues: (1) is the recovery a return of the claimant’s property or a taxable distribution, (2) what reporting forms and taxpayer (or trustee) obligations apply, and (3) how to determine federal tax basis and timing for gains or losses. The answers affect individual customers, general unsecured creditors, debtors, and trustees in both Chapter 11 reorganizations and Chapter 7 liquidations.
This article summarizes the controlling federal tax law and current IRS reporting rules that specifically address digital assets, explains typical fact patterns (return of customer property vs. distribution), and provides a practical checklist for practitioners and affected taxpayers.
How recoveries are classified and the immediate tax consequences for recipients
Return of customer property (no immediate income). If a claimant receives the same digital assets that the claimant previously owned—i.e., the bankruptcy returns the claimant’s property rather than paying value from the bankruptcy estate—this is generally treated as a restoration of property, not taxable income. If the taxpayer previously deducted a theft or casualty loss for the missing asset, rules for recovered property apply and a portion of the recovery may be includible in income to the extent the earlier deduction reduced tax. See IRS Publication 547 for rules on recovered stolen property and the interaction with prior deductions.
Cash distributions or substituted property — possible capital gain or ordinary income. When a customer receives cash (or other property) in settlement of a claim, tax consequences depend on the claimant’s basis in the original asset and whether the distribution is characterized as a return of property or as a settlement/payment. If the distribution exceeds the claimant’s tax basis, a gain (usually capital gain) may result when the claimant is treated as having disposed of the digital asset. Conversely, if the claimant’s basis exceeds the distribution, a loss may be recognized in some circumstances (subject to the usual capital-loss limitations).
Recovery following a prior deduction or loss on deposits. Special rules apply when taxpayers previously claimed a loss because an exchange or financial institution became insolvent (a "loss on deposits"). Publication 547 and related guidance explain when the later recovery is income and how to recompute basis. Taxpayers should carefully document prior returns and any theft/loss claim.
Discharge of indebtedness (debtor-side). For a debtor whose debt is discharged in a bankruptcy case, Internal Revenue Code section 108 generally excludes discharge‑of‑indebtedness income that occurs in a Title 11 case (subject to coordination rules and special adjustments). Practitioners must consult IRC §108 and related rules because the exclusion can affect basis adjustments and other tax attributes.
Trustee, debtor, and broker reporting obligations — current IRS rules and forms
New digital-asset broker reporting (Form 1099‑DA and related rules). The IRS and Treasury adopted final regulations implementing broader broker reporting and gross-proceeds/basis rules for digital assets; the IRS also published instructions for a dedicated digital-asset form (Form 1099‑DA). Brokers that effect sales of digital assets for customers must report transactions on Form 1099‑DA under the new rules and accompanying instructions. Practically, when an exchange or custodian acts as a broker and effects sales or distributes proceeds, it may have significant 1099‑DA (or 1099‑B in limited cases) reporting obligations. These rules are part of the IRS’s final regulations on broker reporting for digital asset transactions.
Exceptions for bankruptcy-related canceled debt information reporting (Form 1099‑C). Generally, creditors file Form 1099‑C to report cancellation of debt, but Form 1099‑C instructions include exceptions for many bankruptcies: a debt discharged in bankruptcy often does not require a 1099‑C if the creditor lacks information showing the debt was incurred for business or investment purposes. Trustees and creditors should follow the Form 1099‑C instructions and coordinate with bankruptcy counsel to decide whether reporting is required.
Bankruptcy estate tax returns (Form 1041) and trustee duties. A bankruptcy estate of an individual is a separate taxable entity in many cases. The trustee or debtor‑in‑possession must file Form 1041 if the estate’s gross income meets the filing threshold; a separate EIN is required for the estate. Trustees must track recoveries, sales of estate assets (including crypto converted to cash), and related gains or losses and report them on the estate return as required. See the Form 1041 instructions and IRS Publication 908 for bankruptcy-specific filing rules.
Practical reporting consequences — examples
- Customer receives original coins returned to a designated wallet: no immediate income; basis is generally preserved (but re-evaluate any prior theft/casualty deduction).
- Customer receives cash equal to USD value at distribution date in settlement: likely a disposition for tax purposes — compute gain/loss using claimant’s basis in the original crypto. Documentation of basis and date received is essential.
- Broker/exchange effects sales to monetize recovered crypto for distributions: the broker may have to file Form 1099‑DA and provide statements to recipients under the new digital-asset reporting rules.
Checklist — what trustees, debtors, and claimants should do now
- Document claim characterization: preserve documents showing whether assets were held as identifiable customer property or commingled estate property.
- Track chain-of-custody and transfer records: blockchain transfer records, custody agreements, and trustee distribution instructions are critical for valuation and timing.
- Preserve basis records and prior tax treatment: gather cost/basis records, prior tax returns (especially any theft/casualty loss claims), and any amended returns.
- Coordinate with counsel and tax advisors before distributions: determine whether distributions are returns of property, sales, or settlements; map anticipated reporting forms (1099‑DA, 1099‑C, Form 1041, or others).
- Prepare for broker reporting and recipient statements: if an intermediary will effect monetization, plan for Form 1099‑DA reporting obligations and recipient statements under the IRS rules.
Bottom line. Tax results depend on facts: whether the claimant ever relinquished ownership, whether previously claimed losses were taken, and whether distributions are in-kind or in cash. Recent IRS action has tightened information reporting for digital-asset transactions—making careful recordkeeping and early coordination between bankruptcy counsel, tax advisors, and trustees essential.
Note: This article summarizes federal tax and IRS reporting principles current as of publication and cites primary IRS and statutory sources. Because tax law and agency guidance change, consult a tax professional and bankruptcy counsel for case-specific advice and to confirm the latest IRS forms, instructions, and effective dates.