How Do You Report Cryptocurrency Gains/Losses to the IRS?
The Internal Revenue Service (“IRS”) is sending thousands of letters to taxpayers who may have failed to report or inaccurately reported their cryptocurrency transactions. It has created a specialized task force within the Criminal Investigation Division to investigate and prosecute individuals who are evading taxes by failing to report or falsely reporting their cryptocurrency income.
As history teaches us, supplying false information or making false statements to a federal agency is worse than admitting the alternative. For instance, the IRS may already have substantial information that certain taxpayers engaged in cryptocurrency transactions either from exchanges such as Coinbase or bank reports. Coinbase, for instance, was obligated by court order to provide transaction data for over 13,000 users. As a result, submitting a false return to the IRS could lead to severe criminal charges and penalties including contempt, tax evasion, and possibly jail time. Retaining an attorney experienced in tax law compliance, recent IRS guidance on cryptocurrency transaction, and federal agency investigations is a taxpayer’s best defense.
The IRS on “Virtual Currencies”
In IRS Notice 2014-21, the IRS defines “virtual currency” as “a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value.” Notice 2014-21 definitively states that the IRS will be treating virtual currency transactions as “property” for U.S. federal income tax purposes. Notice 2014-21 was important because it was one of the IRS’s first publication of guidance on the appropriate tax treatment of virtual currencies.
In 2018, the IRS issued a reminder to taxpayers to report these transactions or be subject to IRS audits and penalties and interest. It stated that more extreme cases involving the failure to report these transactions could lead to criminal charges. In July 2019, the IRS sent over 10,000 letters to taxpayers that have either failed to report all their “virtual currency” income or that did not report this income accurately. The letters (either a Letter 6173, Letter 6174, or Letter 6174-A) demand that taxpayers pay back taxes and file amended returns.
Reporting Cryptocurrency Transactions to the IRS: A Step-by-Step Guide
Any cryptocurrency gain, loss, disposition, or income-triggering event must be reported on your tax return. These events are reported on Form 8949 and can also be reported on Form 1040 Schedule B, Schedule C, and/or Schedule D. This step-by-step guide below outlines how to report cryptocurrency transactions to the IRS:
Determine whether you engaged in crypto transactions.
Starting in 2019, the IRS added a new question to Form 1040, U.S. Individual Income Tax Return: “At any time during [the taxable year], did you receive, sell, send, exchange or otherwise acquire any financial interest in any virtual currency?” The first step is deciding whether this question applies to you. Virtual currencies—such as cryptocurrencies—can include many events such as the following: receiving, selling, sending, exchanging, or acquiring digital currencies such as Bitcoin, other cryptocurrencies, tokens; receiving air drops, mining coins, or initial coin offerings (“ICOs”).
The next step is to answer the IRS’ above question. This question must be answered under the penalty of perjury. If you had no cryptocurrency transactions, the answer is simply “no.” If you did, you must answer “yes.” Answering “no” when the answer is clearly “yes” is very dangerous because the IRS may already have information about your cryptocurrency transactions. This would therefore be criminal perjury and could lead to criminal penalties, interest, tax evasion charges, jail time and a protracted criminal prosecution.
Determine whether your cryptocurrency transactions are ordinary or capital.
The difference between ordinary versus capital can be significant due to the different tax rates that are applicable. This depends on the nature of the transaction, holding period, purpose, and so forth. The following events involving cryptocurrencies can result in capital gains or capital losses: cryptocurrency dispositions, trades, exchanges, etc. that are held for over one year; exchanging digital tokens; or selling air drops. On the other hand, the following events are ordinary income: cryptocurrency dispositions, trades, exchanges, etc. that are held for one year or less; mining coins from a mining business; ICOs; receiving payment from the taxpayer’s employment in the form of cryptocurrency; or receiving air drops.
Determine your cryptocurrency capital gains and losses for the year.
The IRS has made clear that each time the taxpayer disposes of cryptocurrency, they will incur capital gains or capital losses. Capital gains and losses on such dispositions must be recognized. The amount of taxes that must be paid depends on how long the cryptocurrency was held—the “holding period”—as well the taxpayer’s annual income. If the holding period is for one year or less, the taxpayer will have a short-term capital gain or loss. Similarly, if the holding period is for more than one year, the taxpayer will have a long-term capital gain or loss.
After the taxpayer has all their transactions grouped together by holding period, the transactions are netted. Cryptocurrency short-term capital gains are taxed at regular income tax rates and can be as high as 37% for tax year 2020. Cryptocurrency long-term capital gains are taxed at far lower rates of 0%, 15%, or 20%, depending on income. Capital losses incurred during the year are useful because they can offset capital gains on other assets as well as up to $3,000 of ordinary income.
Complete IRS Form 8949, Sales and other Dispositions of Capital Assets
Form 8949 is used for reporting the sales and dispositions of capital assets. While traditionally used for stocks and bonds, this Form is now also used for reporting cryptocurrency capital assets and losses. On this Form, details to be included are the amount of capital gains/losses; whether they are short or long-term gains/losses; and whether the amounts are also reported on Forms 1099-B or 1099-S.
Transfer the net amount on Form 8949 to Schedule D
The amount of your net gain or net loss calculated and written on Form 8949 must be included on Schedule D. Schedule D allows taxpayers to report their capital gains and capital losses from all sources, including crypto activity.
Calculate any cryptocurrency ordinary income.
After everything is complete for reporting capital gains and losses, the taxpayer must then determine and calculate their income involving cryptocurrencies. As mentioned, cryptocurrency can be earned from mining, staking cryptocurrency, receiving airdrops, employment, bonus, and so on. Earning income in this way is a taxable event that must be recognized. That said, different forms need to be used depending on how this income was received.
- Schedule 1 (Form 1040): Taxpayers will use Schedule 1 to report crypto hobby income and crypto income derived from airdrops, forks, and wages. This is reported as “other income” by type and amount.
- Schedule B (Form 1040): Taxpayers will use Schedule B to report their crypto staking interest earned. This is reported as “interest.”
- Schedule C (Form 1040): Taxpayers will use Schedule C to report their cryptocurrencies earned from operating a business. This can include receiving payments from the taxpayer’s employment. Receiving cryptocurrency as payments from cryptocurrency mining would also be reported on Schedule C. Many times, such activities and operations are “self-employment” income.
Complete the remaining sections of the tax return.
Reporting all your cryptocurrency taxable events is the challenging part. Once you have finished, the last step is to complete the rest of the tax form.
Failing to Report Cryptocurrency Transactions
As mentioned, failing to report cryptocurrency transactions or inaccurately reporting these details could lead to civil penalties and interest as well as criminal penalties and jail time for tax evasion and filing a false return. Tax evasion is subject to a fine of up to $100,000 and a five-year imprisonment term and filing a false return is subject to a fine of up to $100,000 and up to three-year prison term. It is now common IRS practice to inquire about taxpayer cryptocurrency transactions, trades, investments, and so on
IRS audits are therefore likely to increase exponentially over the next few years beginning as early as next tax season. Taxpayers need to act proactively by retaining a law firm experienced in not only tax law obligations but also the evolving and ever-expanding crypto sphere.
The IRS will continue to aggressively investigate taxpayer virtual currency transactions using many tools ranging from letters and IRS educational efforts to IRS audits and criminal investigations. Virtual currency transactions remain an ongoing area of concern and focus for IRS Criminal Investigation. Along with targeting individual taxpayers to disclose cryptocurrency transactions, the IRS is also pursuing online exchanges such as Coinbase for taxpayer crypto information. Lying to the IRS when you are under penalty of perjury is an easy way to receive an IRS audit and ultimately lead to perjury and contempt charges, criminal tax evasion and filing false tax return charges, and sometimes jail time. If you have engaged in cryptocurrency transactions and have not reported all transactions, one should get legal advice right away. Contact our knowledgeable attorneys today.