Cryptocurrency (crypto) has been around for more than a decade, and any income generated as a result of crypto has always been taxable. However, it’s only in the last few years that the IRS has stepped up its tax collection efforts for income generated by digital assets such as crypto.
If you’ve been dutifully reporting your gains from cryptocurrency to the IRS, good on you. But there’s still a sizable group of taxpayers who haven’t been doing this.
Are you in this second group of taxpayers? And if so, what does it mean for your taxes? In the rest of this article, we’ll help answer both these questions, as well as discuss what you can do if you discover that you haven’t been reporting your cryptocurrency transactions on your taxes as you should have.
When Is Cryptocurrency Taxable?
Before getting too worried because you didn’t report your cryptocurrency holdings or sales to the IRS, you need to first determine whether your crypto activities are taxable or not. As a general rule, the IRS treats cryptocurrency as a type of property, like a stock. This means you’ll pay taxes on crypto if you obtain it like ordinary income or you realize a gain after you sell or trade it.
If you receive cryptocurrency as a form of payment for something you did, then it’s taxable as ordinary income. For example, if your employer decided to pay you a holiday bonus in bitcoin, then that bonus would be taxed as if your employer handed you a bonus check.
Other ways you could obtain cryptocurrency where it would be taxed as ordinary income include receiving cryptocurrency from an airdrop and/or a hard fork or getting cryptocurrency as a reward for completing a computational task relating to the cryptocurrency, like “mining.”
If you sell or trade cryptocurrency after its value has increased, then you’ll have to pay capital gains taxes on the appreciated value. For instance, if you bought some crypto for $1,000 and then sold it for $5,000 a few months later, you’d have to pay a short-term capital gains tax on the $4,000 increase in value. And if you held on to the cryptocurrency for more than a year before realizing the gain, you’ll pay the long-term capital gains tax.
Another situation where cryptocurrency could be taxable is if you use it to buy something else. If your cryptocurrency increased in value at the time of your purchase, you’ll have to pay capital gains taxes on that increase. The fact that you didn’t sell the crypto and instead “traded” it for something else makes no difference from a tax perspective.
Non-taxable Cryptocurrency Transactions
When is dealing with crypto not taxable? There are several scenarios, such as:
- Receiving cryptocurrency as a gift.
- Buying cryptocurrency with “real” money and holding on to it.
- Transferring cryptocurrency between “wallets.”
- Donating cryptocurrency to a tax-exempt organization.
Additionally, if you lose money with crypto, the loss is certainly not taxable. However, depending on the situation, you may be able to use the loss to offset other gains.
When Do I Have to Report Crypto to the IRS?
If you received cryptocurrency as ordinary income or realized a gain through a transaction involving cryptocurrency, then you need to report that income to the IRS. This requirement applies even if you’re only reporting $1 in income or realized capital gains.
As a practical matter, the vast majority of taxpayers won’t report a cryptocurrency transaction to the IRS if it only results in a $1 gain. But what about a $100 gain or $1,000 gain?
For many taxpayers, they’ll only report something on their taxes if it results in the creation of IRS Form 1099. This isn’t the most lawful of strategies, as tax requirements exist regardless of whether a 1099 gets generated or not. But for most types of earnings and financial gains, the IRS won’t know about it if a 1099 doesn’t get sent.
Given this, you might think that if you don’t get a 1099 relating to your cryptocurrency transactions, then you don’t need to report anything to the IRS. This isn’t a good way of thinking, and there are several reasons as to why not reporting cryptocurrency on your taxes could cause problems for you.
What Happens if You Don’t Report Cryptocurrency Transactions to the IRS?
There are several reasons as to why not reporting your cryptocurrency transactions on your income taxes could cause problems. Here are some of the issues that can occur:
Not taking advantage of capital losses
First, even if you don’t have any gains and therefore owe no taxes, you may still want to report your transactions to the IRS to take advantage of your capital losses. They can offset any other capital gains or up to $3,000 in ordinary income.
You don’t want to lose out on this tax deduction, but even if you couldn’t care less about it, you’ll still want to report your losses to the IRS. If you don’t and the IRS learns that you sold some cryptocurrency, they’ll assume you have taxable income and send you a letter or notice asking you to pay taxes on those “gains.” The IRS will assume you have taxable gains because they may not be aware of your cost basis for the cryptocurrency.
Risk of committing perjury for not reporting crypto
Second, starting a few years ago, the IRS added a question on page 1 of IRS Form 1040 that all taxpayers must answer concerning digital assets (which includes cryptocurrency). This question asked the taxpayer if they received or exchanged a digital asset. If they answered yes, they would have been required to report their digital asset transactions on the applicable IRS form.
If a taxpayer should have answered “yes” to this question but instead lied and answered “no,” they would have committed perjury, a serious criminal offense.
The IRS discovering your unreported crypto
Third, not reporting crypto on your taxes doesn’t mean the IRS can’t find out about your cryptocurrency dealings. The IRS could learn that you traded in cryptocurrency after issuing a subpoena to the cryptocurrency exchange or brokerage firm you used.
Upon receiving this new information, they might review your prior tax returns and confirm you haven’t been reporting your cryptocurrency transactions, so they decide to audit you. Alternatively, maybe the IRS audits your taxes for a reason unrelated to your cryptocurrency and finds out about your crypto dealings that way.
Fourth, there’s a good chance that within the next few years, legitimate crypto brokers and exchanges will have increased tax reporting requirements. This will make it easier for the IRS to learn about the cryptocurrency dealings of taxpayers.
For instance, the IRS has proposed a new regulation that will require cryptocurrency brokers to send a new type of tax form to taxpayers. Called the “1099-DA,” this form would essentially be the cryptocurrency version of Form 1099-B that many stock investors are already familiar with. While not yet law, if it were to go into effect, the IRS would have a new tool for detecting taxpayers who don’t report their crypto activities on their taxes.
Consequences for Not Reporting Crypto to the IRS
Okay, so it’s clear that there are ways for the IRS to learn about your cryptocurrency transactions and that you’re better off reporting them to the IRS. So what happens if you don’t? There are several potential consequences.
Some of these are more of an annoyance or headache. Earlier in this article, we talked about the IRS not having the cost basis for your cryptocurrency sales and expecting you to pay taxes on income that doesn’t exist. If you find yourself in this situation, you might find yourself spending a few hours, days, or weeks looking up previous cryptocurrency transactions to get their cost basis. Then, you’ll send that information to the IRS to explain to them that you didn’t make as much (or any) money as they thought you did.
But some of these consequences can be more serious. From a financial perspective, you can expect to pay hefty penalties and interest on your back taxes. In a worst-case situation, you could face criminal liability for tax evasion and/or tax fraud.
I Realize I Should Have Reported My Crypto to the IRS – What Do I Do Now?
If you think you should have reported prior cryptocurrency transactions to the IRS and failed to do so, you’ll want to consider talking to a tax professional with experience handling digital assets and unreported tax issues. They can review your situation and determine what your options are.
These could include taking advantage of the IRS Voluntary Disclosure Practice program. Here, the IRS considers a taxpayer’s voluntary disclosures when deciding whether to initiate criminal prosecution. If you’re facing non-criminal consequences, like penalties and interest in unpaid taxes, a tax pro can assist you with penalty abatement or help you set up a payment plan.
As for your current taxes, a tax professional can help you properly report your digital asset transactions. This may include completing Form 8949, Schedule D from Form 1040, or Form 709.
The experienced and knowledgeable tax professionals from Seattle Legal Services, PLLC can help you with all of these things. Don’t hesitate to contact us for a free consultation.