Since the introduction of Bitcoin in 2009, new cryptocurrencies have opened vast new avenues to both personal and business investment. Virtual currencies such as LiteCoin, Cardano, and Polkadot have dramatically changed the way the world handles financial transactions, and cryptocurrency investors have found the marketplace quite lucrative.
While investing in new cryptocurrencies may seem like an open field, it is subject to rules and regulations, which are especially important to the way virtual currency earnings are taxed by the IRS.
The IRS recently launched “Operation Hidden Treasure”—a program staffed by a dedicated team of investigators trained in cryptocurrency and virtual currency tracking. The aim of the operation is to track down cryptocurrency tax cheats and to identify those who may have omitted cryptocurrency earnings from their tax returns.
The fees and penalties for omitting cryptocurrency earnings from your IRS filings can be costly. But if you follow a few simple tips, you can save yourself a world of hassles.
Be Aware of the Crypto Crackdown
Operation Hidden Treasure is just the latest in recent IRS efforts to crack down on investors who fail to report cryptocurrency earnings to the IRS. Earlier, the IRS contacted those whose returns did not match their earnings and warned them that they were out of compliance. Known as CP2000, this letter requires recipients to take action—either to support the IRS decision and pay the unpaid tax, or to submit data supporting their version of the return. Failure to meet IRS requirements can result in significant fees and penalties.
Know Which Cryptocurrency Transactions are Taxable
IRS investigators focus on what are called taxable events—transactions in which at least one party’s earnings are subject to federal taxation. For example, buying and holding cryptocurrency is not a taxable event, but if you sell that currency, the proceeds become taxable.
One quick way to check if you owe federal tax on cryptocurrency earnings is to take a basic inventory of your investments. Ask yourself these simple questions…
- Have you received cryptocurrency as compensation for goods or services?
- Have you traded cryptocurrency for flat currency?
- Have you traded one cryptocurrency for another?
- Did you receive cryptocurrency as part of a fork?
(a “fork” occurs when a cryptocurrency on a distributed ledger undergoes a protocol change resulting in a permanent diversion from the legacy or existing distributed ledger—thereafter transactions are recorded on the new distributed ledger) - Did you receive cryptocurrency as part of an airdrop?
(regulations describe an airdrop as “a means of distributing units of a cryptocurrency to the distributed ledger addresses of multiple taxpayers.”)
If you answered “yes” to any of these questions, you may owe tax on your cryptocurrency transactions.
Safely Report Your Crypto Holdings
When dealing with the IRS, it’s essential to be as open and transparent as possible. Reporting your income (from all sources) honestly is the best way to avoid potentially costly fees, penalties, or legal trouble.
If you receive a 1099-K as the result of a cryptocurrency transaction, remember that the same data went to the IRS, so your reported income should be consistent with the amount shown on your 1099-K.
Further, the IRS is actively identifying individuals holding or trading cryptocurrency. For instance, the IRS just issued a John Doe summons on Payward Ventures Inc., and Subsidiaries (a digital currency exchange headquartered in San Francisco, CA) seeking information about U.S. taxpayers who conducted at least the equivalent of $20,000 in transactions in cryptocurrency during tax years 2016 to 2020.
Trading in Crypto? Keep Careful Records
If you’re among those investors who trade regularly between virtual and standard currencies, you’re going to want to take some time to maintain careful records of your transactions. Remember that in the crypto world, capital gains are taxed just as gains made in the stock or bond markets. Cryptocurrency traders are thus required to pay tax on profits made via trading in virtual currencies, or between virtual and hard currency.
A Note to Miners
Some investors choose to mine virtual currency rather than to buy or trade for it directly. The IRS regards mined coins as having the value in real currency that they possessed at the time they were mined. So if you mined Bitcoin or other cryptocurrency when it stood at a value of $5,000, that remains the value of the transaction’s taxable gain for the purposes of your IRS return.
Trading Crypto for Flat Currency
By IRS rules, trading crypto for flat currency is regarded as a taxable event that will generate a capital gain or loss. All capital gains made by exchanging crypto for flat currency are subject to taxation, as are gains made through the sale of stocks or bonds.
Get Compliant Now
If you have conducted transactions in cryptocurrency and are out of compliance with IRS regulations, the time to get compliant is now. If you notice a discrepancy, or have received any communications regarding your outstanding tax balance, consult with a tax lawyer. Remember only attorneys can provide you with attorney-client privilege.
At Moskowitz LLP, our skilled tax attorneys have tackled virtually every tax challenge out there. And we are confident we can help you. If you’ve traded in cryptocurrency and have compliance issues, or if you’re simply looking for a way to reduce your tax burden, contact us today!
Moskowitz LLP is a tax law and accounting firm that has dedicated over 30 years to representing individuals and businesses with civil and criminal tax problems, cleaning up accounting and tax messes, and providing tax and accounting advisory services. We offer practical and affordable tax and accounting solutions, business services, estate planning and administration. Remember a blog post or email blast is not a substitution for obtaining personal legal and tax consultation. This information is not intended to be legal or tax advice nor does it form an attorney-client relationship between us.