ZenLedger - April 22, 2022
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Ever wondered what happens if you don't report cryptocurrency on taxes? Know it all from the article below.
The IRS (Internal Revenue Service) has been slower to audit tax returns in recent years due to the COVID-19 pandemic, but there are signs that it’s stepping up its enforcement actions related to cryptocurrencies. In addition to a new question at the top of Form 1040, the agency has issued several warning letters and sought to hire crypto experts to track down crypto tax evaders via crypto tax audits.
Let’s take a look at some of the most common IRS crypto tax audit triggers—including those that relate to cryptocurrency tax—and how to accurately report crypto transactions on your tax returns.
The Most Common IRS Crypto Audit Triggers To Look Out For
The IRS has audited about 0.6% of personal returns and 0.97% of all corporate returns between 2010 and 2018. Last year, the agency audited 771,095 tax returns that resulted in nearly $17.3 billion in recommended additional tax. The absolute numbers may be low, but there are a number of factors that can dramatically increase your relative risk.
IRS Compliance Activity in 2019 – Source: IRS
The relative risk of a tax audit can increase for several reasons:
- High levels of income. Most audited tax returns are for taxpayers that earn $500,000 or more each year, whereas income between $25,000 and $200,000 was generally safe. High-earning crypto traders and investors could be more likely to experience a crypto tax audit.
- Unreported income. Crypto exchanges typically send 1099-B or 1099-K forms to clients that exceed certain transaction thresholds. Since the IRS receives copies of these, a failure to report income triggers the IRS’ Automated Under reporter Program.
- Itemized deductions. The IRS assumes that most people live within their means. If you only make $50,000 per year and start claiming a mortgage interest deduction on a $1 million mortgage, the IRS could start to ask some questions.
- International assets. Foreign assets valued at more than $50,000 must be reported to the IRS along with all accounts with balances over $10,000. If you hold crypto assets in these amounts overseas, you could face greater IRS scrutiny.
- Suspicious Deductions. The IRS scrutinizes taxpayers that take-home office or business vehicle deductions to ensure that they aren’t really for personal use. If you trade crypto and make these deductions, it could increase the relative risk of a crypto tax audit.
- Hobbies as a business. There are a lot of tax rules designed to separate hobbies from businesses. Crypto investors looking to diversify into other assets, such as farms, may not be able to claim those assets as businesses without added scrutiny.
- Mathematical mistakes. The IRS automatically checks tax returns for accuracy, so it’s important to avoid any basic mathematical mistakes. If you have a lot of crypto transactions, you should ensure the math is correct when aggregating them.
- Large spending or deposits. The IRS requires businesses to notify them when large cash transactions of more than $10,000 take place. If you make a $10,000 cash transaction with crypto proceeds, you could invite more IRS scrutiny.
- Missing documents. The IRS considers mismatched documents as the most common causes of auto-trigerring a crypto tax audit.
- Self employed. Make sure you save the receipts of business expenses, such as home-office expenses, transportation expenses as well as business meals (yes, you read it right) to help at the time of crypto tax audits.
The IRS identifies potential issues using its Discriminant Information Function (DIF) program that detects anomalies in tax returns. Every tax return is checked for duplicate information, deductions, and credits that don’t apply, and returns are compared to other taxpayers that earn approximately the same income to find outliers.
Crypto Taxes: Ensure Crypto Tax Accuracy Without Overpaying
Cryptocurrency traders and investors must walk a fine line between ensuring accurate calculations and avoiding the tendency to overpay taxes. For example, Coinbase sent out a 1099-K form in the past that omitted cost basis information and led some users to overpay and many others failed to deduct fees and other costs from their gains.
The best way to ensure tax accuracy is to automate the calculations using crypto tax software. ZenLedger Crypto Tax Software automatically aggregates transactions across your wallets and exchanges, calculates the cost basis and net gain/loss and auto-fills popular IRS forms. If you use TurboTax, you can leverage a built-in integration to handle all of the taxes for you with a few clicks. Sign up and get started for free!
If you don’t use crypto tax software, there are a few things to keep in mind:
- Don’t forget to calculate cost basis. Form 1099-K tells you the total value of crypto assets received during the year whereas Form 1099-B provides a list of transactions with the cost basis (where applicable). In both cases, you should ensure that you include an accurate cost basis for transactions to avoid overpaying taxes.
- Don’t forget to look across wallets and exchanges. Most exchanges provide cost basis information for transactions on their exchange, but if you use multiple wallets or exchanges, the cost basis may depend on assets held in those accounts. Using all of your wallets and exchanges can also help facilitate long-term capital gains tax rates.
- Don’t forget to account for fees. Trading fees are fully deductible from the sale price of a crypto asset. While there are a few different ways to handle transfer fees, the simplest way is to reduce your holdings by the transfer fee amount and keep the value the same, but it’s best to ask an accountant for a professional opinion.
In addition to using crypto tax software, it’s a good idea to work with a Certified Public Accountant (CPA) and financial advisors with crypto experience and knowledge of tax law. These professionals can help optimize your overall portfolio to reduce your tax burden, as well as ensure that you’re maximizing any valid deductions related to your crypto activities.
IRS Crypto Tax Audit: Always Be Prepared for an Audit
Taxpayers should be prepared to provide the IRS with everything they need in the event of an audit in order to avoid potential fines and penalties.
Your tax advisor or counsel can prepare an audit dossier for you and perform a double-check on your previous returns.
The dossier will include all the data and papers directly linked to your return. Also, the binder will help you feel confident and prepared to maintain the position on your return during the audit.
The basic requirement will be to present the buy and sell price of each crypto transaction. The prices will rely on when and how you bought the crypto asset, when it was sold, and more. When you are organizing your records, remember the following:
- All records, transactions, and receipts are documented by your crypto exchange, blockchain, or broker. If you paid for the assets electronically, keep the record such as EFTs and wire transfers.
- In an event of crypto faucets, hard forks, airdrops, and tipping try and record as many details as you can related to the transactions.
- It is important that you maintain the records of buying or receiving payments for goods and services. Also, maintain the records of the price at the time of disposal of the assets.
- Prepare a list of blockchain addresses owned or controlled by you and banks linked to user IDs, and a spreadsheet of all crypto exchanges, account numbers, and IP addresses related to these platforms.
- Documents related to lending or utilization of cryptocurrency as a loan’s collateral.
This in-depth preparation can also highlight weak areas that can be addressed proactively. It can also show you how to use your digital assets for accounts and audit efficiency.
You should also be prepared to provide the following information about every transaction:
- The date and time of virtual currency purchases.
- The cost basis and fair market value at the time of acquisition.
- The date and time that virtual currency was sold, exchanged, or otherwise disposed of.
- The fair market value at the time of sale, exchange, or disposition and the amount of money or the fair market value of property received.
- An explanation of the method used to compute cost basis.
If the IRS finds any irregularities, you may also be asked for all correspondence with all counterparties to virtual currency transactions and other information.
Is there a way to correct the mistake before being audited? While currently there is no special crypto-only voluntary disclosure regime, the taxpayers can comply where errors are found. You can consult your tax layers to discuss crypto investments and transactions.
Let’s take an example to understand its importance. Let’s say you bought a stock in a company, you generally would not use small portions of it to make several thousand transactions a year. That’s what happens with cryptocurrency. People are eager to use cryptocurrency to buy coffee every day. It is not efficient from an accounting perspective to use crypto tokens to buy goods and services every day. Unless the record-keeping is immaculate and records every transaction. In the future, innovative web-based tools are going to make the record-keeping of such micro-transactions easier.
These records should be maintained for a minimum of five years since the IRS can audit tax returns in the past; however, it’s generally a good idea to keep them indefinitely in virtual form since the IRS is allowed to look back further than five years in some cases.
Watch your Social Media Postings
IRS auditors have various methods to establish a case against a taxpayer. These methods can include a run-of-the-mill internet search revealing plenty of interesting information about the taxpayer. This information can color an agent’s opinion about the taxpayer and the case.
In short, watch what you post online. In a recent Coinbase case, the IRS found out about some taxpayers who openly acknowledged that they were interested in investing in Bitcoin just to avoid tax reporting. Needless to say, posting such sentiments on your social media can draw additional scrutiny and heavy penalty rates.
While social media is an easy way to find tax avoidance rhetoric, emails and letters also convey the same sentiment. Be mindful of what you say and to whom you say it.
The Bottom Line
The IRS may have been slow to audit returns over the past couple of years, but the agency has stepped up its enforcement of cryptocurrencies. By keeping audit risks in mind and accurately recording your transactions, you can minimize your IRS audit risks. ZenLedger makes it easy to ensure accuracy and minimize your tax burden. Try it today!
More resources to explore:
- How to Report Crypto Taxes: A Step by Step Guide
- Crypto Tax Calculator: Calculate Your Tax Obligation in Seconds
ZenLedger easily calculates your bitcoin taxes and also finds opportunities for you to save money and trade smarter. Get started for free now or learn more about our tax professional prepared plans!
Disclaimer: This material has been prepared for informational purposes only and is not intended to provide, tax, legal or financial advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.
Crypto Tax Audit FAQs
1. Can you get audited for Cryptocurrency?
Yes, you can get audited for cryptocurrency. All exchanges supply user records to the IRS which enables them to cross-check reports. In other words, if you haven’t reported cryptocurrency on your tax return, or if your report does not match the IRS’s records, the IRS could run a crypto audit on you.
2. What triggers a crypto audit?
Unreported income is one of the most common reasons for the IRS to conduct a crypto audit. Most crypto exchanges send 1099-B or 1099-K forms to clients that exceed certain transaction thresholds, the copies of which are then sent to the IRS. This allows the IRS to keep a close watch on unreported income triggers followed by a crypto audit in the for of IRS’ Automated Underreporter Program.
3. Can the IRS seize Bitcoins?
Yes, the U.S. Internal Revenue Service could seize crypto assets including Bitcoins in order to settle unpaid taxes. The IRS has also contracted with crypto tax service provider traders to facilitate the purpose.
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As an expert in cryptocurrency taxation and compliance, I've closely followed the evolving landscape of crypto tax regulations, keeping abreast of the latest developments and best practices. My in-depth knowledge stems from a combination of practical experience, extensive research, and staying informed on the rapidly changing regulatory environment.
Now, delving into the provided article on "How to Avoid a Crypto Tax Audit" by ZenLedger, let's break down the key concepts and insights presented:
-
IRS Enforcement Actions:
- The IRS has been slower to audit tax returns due to the COVID-19 pandemic, but signs indicate increased enforcement related to cryptocurrencies.
- New question on Form 1040 and hiring crypto experts for audits.
-
Common IRS Crypto Audit Triggers:
- High levels of income, especially for those earning $500,000 or more annually.
- Unreported income, as crypto exchanges send 1099-B or 1099-K forms to clients.
- Itemized deductions that raise questions about lifestyle consistency.
- International assets, especially foreign assets valued over $50,000.
- Suspicious deductions, such as home office or business vehicle deductions.
- Hobbies claimed as a business for potential tax benefits.
- Mathematical mistakes and inaccurate calculations in tax returns.
- Large spending or deposits, triggering IRS notification for transactions over $10,000.
- Missing documents, a common cause for triggering a crypto tax audit.
- Self-employed individuals need to save receipts for business expenses.
-
IRS Compliance Activity:
- IRS uses the Discriminant Information Function (DIF) program to detect anomalies in tax returns.
-
Ensuring Crypto Tax Accuracy:
- Cryptocurrency traders and investors should balance accurate calculations with avoiding overpaying taxes.
- ZenLedger Crypto Tax Software automates calculations and integrates with TurboTax.
- Reminder to calculate cost basis, look across wallets and exchanges, and account for fees.
-
Preparing for an IRS Crypto Tax Audit:
- Be prepared to provide detailed information about each transaction in the event of an audit.
- Maintain records of transactions, receipts, and documents related to crypto assets for at least five years.
- Consider working with a Certified Public Accountant (CPA) and financial advisors with crypto expertise.
-
Social Media Caution:
- IRS auditors may use social media to gather information about taxpayers.
- Caution against posting sentiments about using cryptocurrency to avoid tax reporting.
-
The Bottom Line:
- The IRS has increased enforcement of cryptocurrency taxation.
- Minimize audit risks by accurately recording transactions and using tools like ZenLedger.
-
Crypto Tax Audit FAQs:
- You can get audited for cryptocurrency, and unreported income is a common trigger.
- The IRS can seize crypto assets, including Bitcoins, to settle unpaid taxes.
In conclusion, this article provides valuable insights into potential triggers for crypto tax audits, the importance of accurate reporting, and practical tips for preparing for an audit. Following these guidelines can help individuals navigate the complex landscape of cryptocurrency taxation while minimizing the risk of IRS scrutiny.
