Cryptocurrency Taxes: The Ultimate Guide to Tax Consequences
Cryptocurrency Investors Can Face Severe Consequences for Failing to Report Transactions to the IRS.
While cryptocurrency investing used to largely fly under the radar, in today’s world, it has gone mainstream. Bitcoin made national headlines when it reached nearly $20,000 in late 2017; and, since then, casual investors have flocked to trading apps and exchanges hoping to cash in on the cryptocurrency craze.
This increase in notoriety has also led the IRS to begin aggressively enforcing cryptocurrency investors’ income reporting and tax payment obligations. It launched an international “virtual currency” compliance campaign in mid-2018; and, in mid-2019, it began sending “educational letters” to tens of thousands of cryptocurrency investors warning of the risks of noncompliance. As a result, more than ever before, investors in Bitcoin and other cryptocurrencies need to carefully track and record their transactions, and they need to be prepared to defend themselves in the event of an IRS audit or criminal cryptocurrency tax fraud investigation.
Are There Severe Tax Implications to Investing in Bitcoin and Other Cryptocurrencies?
The IRS has taken the position that cryptocurrency holdings constitute “property” for federal income tax purposes. This means that investment transactions (purchases and sales) involving Bitcoin and other cryptocurrencies are taxable events, and cryptocurrency investors have an obligation to report these transactions just as stock market investors have an obligation to report purchases and sales of corporate securities.
This also means that there are potentially severe tax implications to investing in Bitcoin and other cryptocurrencies. While cryptocurrency investors who properly report their transactions to the IRS will only have to pay ordinary income or capital gains tax as required by the Internal Revenue Code, investors who fail to report their holdings and transactions can face interest, financial penalties and other consequences. Although cryptocurrency investors who mistakenly failed to report their virtual assets to the IRS are unlikely to face criminal prosecution (liability for back taxes and standard interest and penalties is more likely, at least for the time being), investors who appear to have intentionally evaded their federal reporting and payment obligations could be at risk for criminal fines and federal imprisonment.
IRS Warning Letters for Cryptocurrency Investors and Bitcoin Investors
In July 2019, the IRS began sending warning letters (which it called “education letters”) to cryptocurrency investors. In a press release announcing the initiative, the IRS Commissioner stated: “Taxpayers should take these letters very seriously by reviewing their tax filings and when appropriate, amend[ing] past returns and pay[ing] back taxes, interest and penalties.”
While the stated purpose of the IRS’s cryptocurrency warning letter initiative was to, “help taxpayers fully understand and meet their obligations,” the initiative has another practical consequence for cryptocurrency investors as well: Once a person receives a warning letter from the IRS, it is virtually impossible for that person to claim that he or she unknowingly failed to comply with the law.
If you are a cryptocurrency investor and you have received a warning letter from the IRS, you must promptly assess your reporting and payment obligations. If you have not yet received a letter, your obligations are no different. All cryptocurrency investors are subject to the requirements of the Internal Revenue Code, and failure to meet these requirements (including failure to correct past violations) can have costly consequences.
What is Needed When Filing Taxes for Cryptocurrency Investments?
When filing taxes related to cryptocurrency, one of the first questions that needs to be answered is, “What constitutes a taxable event?” While the same general principles apply to cryptocurrency as apply to other types of property, the unique nature of cryptocurrency creates confusion for many investors. While tax reporting requirements will vary depending on the amount, nature, and other unique aspects of each individual transaction, as a general rule, taxable events involving Bitcoin and other cryptocurrencies include:
- Selling cryptocurrency (or trading cryptocurrency for U.S. dollars or a foreign fiat currency)
- Trading one type of cryptocurrency (i.e. Bitcoin) for another (i.e. Litecoin)
- Paying for goods or services with cryptocurrency
- Accepting payment for goods or services in the form of cryptocurrency
- Earning investment income from cryptocurrency holdings
Importantly, the fact that a transaction constitutes a taxable event does not necessarily mean that any federal income tax is owed. However, it does mean that the cryptocurrency may have an obligation to report the transaction to the IRS, and it also means that all cryptocurrency transactions need to be carefully evaluated for their potential tax implications.
Once you determine whether a cryptocurrency transaction is a taxable event, you then need to determine whether any tax is owed. From an investment perspective, this requires knowledge of your basis in the virtual asset (i.e. what you paid), its value at the time of sale and the duration that you held the cryptocurrency. From a legal perspective, it requires a comprehensive understanding of the relevant provisions of the Internal Revenue Code, knowledge of the specific tax forms you need to file, and the ability to determine whether you owe interest or penalties due to an untimely filing. If you have not kept a record of your cryptocurrency transactions, this can present a significant challenge; however, failure to keep records is not an excuse for failing to report cryptocurrency transactions or pay taxes to the IRS.
The Importance of a Tax Lawyer for Cryptocurrency Tax Assistance
Due to the relative novelty and complexity of dealing with federal tax issues related to cryptocurrency investing (as well as the potential penalties for noncompliance), most cryptocurrency investors will benefit greatly from speaking with an experienced federal tax attorney like Kevin E. Thorn. As cryptocurrency transactions can have implications for local, state and international taxes as well, it is important to choose an attorney who has experience dealing with compliance, audits, investigation and enforcement in each of these areas. Some of the ways that a tax lawyer can assist with cryptocurrency transaction reporting and tax filings include:
- Determining what transactions need to be reported as taxable events
- Determining whether any taxable events trigger tax liability
- Assessing risk and compliance options related to delinquent cryptocurrency tax filings
- Filing new and amended returns that accurately report cryptocurrency transactions
- Providing representation for IRS audits and criminal matters involving the IRS Criminal Investigation Division
- Negotiating offers in compromise and deferred prosecution agreements when necessary
- Developing tax strategies for avoiding future issues related to Bitcoin and other cryptocurrency investments
Do You Need a Cryptocurrency Tax Lawyer? Call 202-349-4033
Frequently-Asked Questions (FAQs): Federal Income Tax and Cryptocurrency
Q: How Does the IRS Audit Bitcoin and Other Cryptocurrency Investors?
Bitcoin and other cryptocurrency audits are similar to all other types of IRS audits in that the goal is to determine whether and to what extent a taxpayer has failed to meet his or her obligations under the Internal Revenue Code. Some cryptocurrency investors may be singled out for auditing as a result of their information being disclosed by third parties (such as Coinbase), while others may be targeted due to apparent inconsistencies or omissions in their tax returns.
Q: Is Gain on Bitcoin and Other Cryptocurrency Investments Taxable Income?
Generally speaking, yes. At the federal level, investment income from Bitcoin and other cryptocurrencies is treated no different than investment income from other traditional investment vehicles.
Q: How is Cryptocurrency Taxed?
Similar to other investments, cryptocurrency investments are taxed when they generate income for the investor. Due to the nature of cryptocurrency, virtually any cryptocurrency transaction (including buying products or services) aside from buying cryptocurrency with U.S. dollars has the potential to create a domestic tax obligation.
Q: In Which Jurisdictions Must You File Tax Returns Related to Cryptocurrency?
If you are a U.S. citizen or U.S. resident, you “are subject to tax on worldwide income from all sources.” You may have state and local tax obligations as well depending on where you live. If you are a foreign citizen or a U.S. citizen living abroad, you may have international tax reporting obligations as well.
Q: How Do I Account for Cryptocurrency Gains?
When it comes to taxation of cryptocurrency, accounting for gains presents one of the biggest challenges for many investors. Investors must maintain comprehensive logs of their cryptocurrency transactions so that they can accurately report and calculate any taxes they owe.
Q: Isn’t Cryptocurrency Supposed to be Anonymous?
No, not entirely. While a discussion of the blockchain and encryption technology underlying cryptocurrency forms and exchanges is well beyond the scope of this discussion, there are ways that cryptocurrency investments and transactions can be traced to individual investors.
Q: Can You Write Off Cryptocurrency Losses on Your Taxes?
Potentially, yes. Since cryptocurrency investments are treated similarly to other types of investments for federal tax purposes in the U.S., the same general rules regarding gains and losses apply.
Contact Washington D.C. Tax Attorney Kevin E. Thorn, Managing Partner of Thorn Law Group
If you are a cryptocurrency investor, it is imperative that you have a clear understanding of the tax laws that apply to you. If you have received a letter from the IRS, then you need to take steps to protect yourself immediately. To discuss your situation with Washington D.C. tax attorney Kevin E. Thorn, Managing Partner of Thorn Law Group, call 202-349-4033 or request a confidential consultation online now.