Rug Pulls: Your Complete Guide

Learn everything you need to know about crypto rug pulls, including how crypto rug pulls work, whether rug pulls are illegal, and what to do if you've been the victim of a rug pull.

What is a crypto rug pull?

Rug pulls are when a new token is created, usually by an anonymous party. The creators will hype and pump the new token through social media and other platforms, and just when the token reaches an all-time high in value, they’ll abandon the project, with all the investors' funds. The term comes from the phrase to "pull the rug out from under you".

The name rug pull comes from the idea of the investors having the rug pulled out from underneath their feet. The project is going well, prices are skyrocketing, and then suddenly it all comes crashing down.

How do crypto rug pulls work

Rug pulls work by exploiting trust and hype within DeFi ecosystems, particularly on decentralized exchanges where listing a token is easy and often unregulated.

Developers create a new cryptocurrency token and generate buzz, often through social media, influencers, or misleading marketing, to attract investor interest. As more people buy in and the token's price rises, the developers execute a premeditated exit strategy.

This can take several forms: dumping their own large token holdings, draining the liquidity pool of valuable assets like ETH, or using smart contract code to block others from selling. Once the developers cash out, the token’s value collapses, leaving investors with losses and no recourse for recovery.

Types of crypto rug pulls

There are actually a couple of different types of crypto rug pulls: dumping, liquidity pulls, and limiting sell orders.

A dumping rug pull occurs when the creators of a token withhold a large portion of the circulating supply. Once the token’s price peaks, the creators quickly sell off their holdings. This sudden sell-off causes the token’s price to crash, leaving investors with worthless assets. This tactic is also known as a pump-and-dump scheme.

Liquidity pulls are the most common kind of rug pull and typically exploit decentralized exchanges. A fraudulent developer lists a new token on a dex, pairing it with a well-known cryptocurrency like ETH. They then promote the token heavily, drawing investment into the liquidity pool and increasing the token’s value. Once the price reaches a high point, the developer withdraws all the ETH from the pool, leaving other investors unable to recover their funds.

Limiting sell orders is a more technical form of rug pull, though less common. A notable example is the Squid Game token scam. In these cases, the developer programs the token’s smart contract to restrict sell functionality; only their wallet address is authorized to sell. Once the token price surges, they sell off their holdings, while all other holders are locked out, rendering their tokens worthless.

Now you know the common kinds of rug pulls and how they work, you need to know how to avoid them.

Read next: 10 Biggest Rug Pulls

How to avoid a rug pull

Hey, have you heard of this new token? It’s already shot up more than 200% in value - you should get in now so you don’t miss out. Celebrities are promoting it, so you know it’s legit.

Sound familiar?

It should. Rug pulls all work slightly differently, but the pattern they follow is the same. It’ll be a relatively unheard-of token that’s suddenly getting shilled everywhere you look.

More recently, celebrities have joined the fray. The developers often pay them to promote their new token. Kim Kardashian and Floyd Mayweather are both being sued over their promotion of EthereumMax, Steven Seagal was fined more than $300,000 by the SEC after promoting B2G, and Lil Uzi promoted the Eternal Beings Solana NFT rug pull.

There are some other common rug pull red flags, including:

• The project appeared out of nowhere: Reputable crypto projects don't just appear overnight. They start development and slowly build interest and investment as they progress.

• Unclear or unavailable whitepapers or roadmaps: Like above, a decent project has clear goals and aims. All the best and most profitable DeFi projects have clear development plans and a coherent whitepaper explaining them. Often with rug pulls, the whitepaper or roadmap may be entirely absent. If they do have one, it's often incoherent and makes huge claims that there's simply no way of backing up or executing.

• Extensive marketing: You don't need to sell the best crypto projects. Maker, Curve, and Uniswap didn't become popular through shilling. The main selling point is the use case and the problem it seeks to resolve. Most rug pulls have no use case, so instead, they shill. This could be through paid celebrity promotions or extensive bots, or even both.

• Low liquidity: Liquidity matters in crypto. The lower the liquidity, the more risky an investment you're making. Of course, all new projects - even reputable ones - may have low liquidity initially. Most reputable projects will have a liquidity lock-up of sorts to ensure the developers can't empty the funds randomly. However, it's important to note that a liquidity lock-up is only as secure as those coding it.

• Anonymous developers: Anonymity is important in crypto, but there are some well-known developers out there. Normally, the most reputable projects have developers who've worked on other well-known projects.

• Skyrocketing values: Crypto value grows based on demand and supply. While it's difficult to predict what the "normal" growth is for any crypto due to the volatility of the market, reputable projects will have relatively steady and sustainable growth that aligns with their development phases. If the value of a token skyrockets out of nowhere, it's almost certainly about to come crashing down soon.

• Unrealistically high yields: If a given project is promising a huge amount of growth or high yields within a given time frame, it’s likely a rug pull. While there are many yield farming protocols out there now offering great yields, these are generally with established tokens and built on top of existing protocols. If it’s a token you’ve never heard of claiming 200% APY, it’s too good to be true.

• Big claims from new NFT projects: NFT rug pulls are a particularly recent occurrence, thanks to the general hype in the market. The reality is, nobody knows which NFT projects will take off and which won’t. If an NFT project is claiming that you’ll be able to sell your NFT for huge gains in a short period of time, it’s likely not true; they’re just looking for investment.

Are crypto rug pulls illegal?

While rug pulls are always unethical, it’s not always clear whether they’re illegal. It all depends on the kind of rug pull and whether it’s a so-called hard or soft rug pull.

Hard rug pulls are malicious from the start. This means the developers set out with every intent to defraud investors by adding malicious coding into the token, like with the Squid Game Token.

Soft rug pulls, meanwhile, aren’t so clear-cut. This refers to when token developers dump their crypto assets in a short space of time, leaving a worthless token behind. Dumping is unethical, but it isn’t technically fraudulent in many instances.

What to do if you’re part of a rug pull?

While we can all do our best to look out for the red flags that can indicate a rug pull, the reality is scammers are getting smarter and better at what they do just as quickly. This means, unfortunately, unless the market is eventually somehow better regulated, rug pulls are going to happen.

So, what can you do if you’re involved in a rug pull?

• Connect with the community involved: If there’s a criminal case being built, they’ll be able to point you in the right direction of the authorities to contact (tldr; don’t call 911 about your crypto).

• Contact the platform involved: Many platforms, like SolPad, have been able to offer investors at least some of their investment back.

• Recoup what you can: Many investors see the price dropping and wait too long to see how it plays out. If you can sell, sell while you can. It rarely gets better.

How do I report a rug pull on my tax return?

A very common question we get at Koinly is, “I’ve invested in a token that was rug-pulled, can I count this as a capital loss?”

The IRS makes it clear that lost or stolen crypto doesn’t qualify as a capital loss. However, rug pulls fall into a gray area. Technically, a rug pull isn’t considered theft; you still hold the token and control the asset. The issue is that the token’s value has crashed, often becoming virtually worthless.

At this stage, your loss is unrealized. To claim a capital loss, you need to realize it by disposing of the token. This typically means getting rid of the asset in a way that counts as a sale or abandonment for tax purposes. Common options include:

• Sell the token, even for a tiny amount.

• Trade it for another token.

• Send it to a burn wallet, which effectively disposes of it at a $0 value.

Once you’ve realized the loss, you can report the difference between what you paid for the token and what you received (if anything) as a capital loss on your tax return. You can then use that loss to offset capital gains, reducing your overall tax bill. If you don’t have any gains, you can carry the loss forward to offset gains in future years.

How Koinly helps calculate crypto taxes

Koinly is a crypto tax calculator that helps you figure out both your unrealized and realized capital losses.

All you need to do is sync the wallets, exchanges, and blockchains you use with Koinly, and it'll import your entire transaction history across your whole portfolio. You can do this via API or by importing a CSV file of your transactions.

Once you’ve added your wallets, Koinly identifies the cost basis of all your assets and each taxable transaction, and calculates your subsequent capital gains and losses, as well as the fair market value of any crypto income. The tax optimization dashboard can also help you identify your unrealized losses from rug pulls and simulate realizing those losses so you can see how it would impact your tax bill.

All this information is available in a free tax summary. If and when you want to download your tax report, upgrade to the paid Koinly plan that suits you and download a crypto tax report when you need to file your tax return.

Koinly makes crypto tax simple. Try it free today.