Posted On October 23, 2020
Cryptocurrency Account Holders: Prepare for an IRS Tax Audit

Cryptocurrency Account Holders: Prepare for an IRS Tax Audit

The IRS views the sale or exchange of cryptocurrency as a taxable event. This includes receiving virtual currency for services performed or property received. Account-holders may unwittingly trigger the need to report capital gains and losses when filing federal income taxes. Failure to report these transactions involving virtual currency could lead to a tax audit.

How the IRS Treats Cryptocurrency

As defined by the IRS, cryptocurrency is “a digital representation of value” that functions “as a unit of account, a store of value, and a medium of exchange.” Some cryptocurrencies are convertible and could have equivalent values in one or more traditional currencies. A few well-known examples of cryptocurrencies are Bitcoin, Ethereum, and Ripple. These virtual currencies use cryptography to secure transactions that are recorded digitally on a distributed ledger, often a blockchain that provides proof of ownership and transactions.

The IRS issued its first formal guidelines for how cryptocurrency should be treated, concluding that virtual currency is considered property for federal tax purposes. This means many cryptocurrency transactions must be treated as capital gains or losses as opposed to ordinary income. For example, a Bitcoin might be exchanged for an Ethereum. This would be a taxable transaction and would need to be reported as a capital gain or loss on the taxpayer’s federal tax filing.

Cryptocurrency may be treated as ordinary income if the transaction constitutes income. This is the case if the currency is earned through mining or the taxpayer was paid in cryptocurrency. Events such as the purchase or investment in cryptocurrency do not trigger a taxable event, similar to purchasing publicly-traded stock.

Cryptocurrency Account Holders Under Closer Scrutiny

Admittedly, the IRS is not an expert where cryptocurrency is involved. However, auditors are ramping up efforts to make sure that cryptocurrency account holders pay taxes owed. Consultants have been hired to help identify cryptocurrency investors that are shortchanging the IRS on tax returns. Hiring these outside contractors will allow the IRS to significantly increase the volume and depth of audits performed.

As of 2019, Form 1040 asks whether filers received, purchased, sold, exchanged, or acquired cryptocurrency. Taxpayers who fail to properly report cryptocurrency earnings or income on federal tax filings will be subject to tax penalties and interest on taxes owed if an audit is performed.