Properly Reporting Cryptocurrency for Tax Purposes

Experienced Tax Audit Lawyer

With bitcoin and other cryptocurrencies gaining more interest and increase in value, the Internal Revenue Service has made an effort to up its enforcement efforts on this issue. Now, more than ever, investors in these volatile assets need to understand their potential tax impact and the potential consequences of non-compliance with their related tax obligations.

Treatment of Cryptocurrency as Property

A cryptocurrency sometimes referred to as virtual currency, is treated by the Internal Revenue Service as property. In particular, Notice 2014-21 dictates that “general tax principles applicable to property transactions apply to transactions using virtual currency.” In layman’s terms, that means that cryptocurrency is not treated as currency – which would be subject to potential currency gains and losses even if not sold – but is instead only subject to tax when it is sold. For those not involved in the active trade of these assets, gains and losses are generally reportable as capital gains or capital losses. Given the substantial increase in value in bitcoin in the past years – particularly in the last year – taxing authorities have released more guidance on how to properly treat income associated with these assets. In determining the income associated with cryptocurrency, investors must calculate the difference between the fair market value of the cryptocurrency when it is purchased and when it is sold. The difference in value will be deemed the amount of a taxpayer’s gain or loss.

For many taxpayers, the calculation of gains and losses is not straightforward. For instance, many taxpayers will exchange one form of cryptocurrency for another form of cryptocurrency. Others only dispose of only a portion of the cryptocurrency at a given time. Accordingly, investors need to keep track of cost basis reporting – on a per lot or unit basis – to accurately report associated income on their tax returns. To do this, it is necessary to keep a log of specific dates when cryptocurrency is purchased or sold and to note what the fair market value, measured in U.S. currency, is on the specific date related to the transaction. Where one engages in many transactions and/or exchanges one form of cryptocurrency for another form of cryptocurrency – which is deemed a wholly separate asset resulting in a taxable transaction – proper tax calculations may require detailed logs. If an investor transacts in these assets through an exchange, this information may be readily available; however, if otherwise, taxpayers may face a more onerous process. Nonetheless, these logs are essential to avoid additional tax or penalties in the event of an audit.

Other Tax Reporting Issues Can Complicate Matters

Even if information relating to the fair market value of cryptocurrency is readily available, other tax concepts can further complicate the matter. For example, if one receives cryptocurrency in exchange for a service rendered or goods furnished, the receipt of cryptocurrency will not initially be treated any differently than receiving cash. However, the recipient will then need to track any fluctuations in value as it will affect their future income. In addition, if a taxpayer is actively engaged in the sale of cryptocurrency, they may be impacted by the “wash sale” rules. These rules provide that where one engages in sales of substantially the same asset within a short period of time, the basis from the prior asset will be preserved in the new asset. These rules prevent tax loss harvesting for specific lots or units of an asset. Furthermore, where cryptocurrency is converted into another type of cryptocurrency or a “hard fork” occurs, other specific tax requirements may apply. These are just some of the many little-known rules that can be implicated by investing in cryptocurrency.

Enforcement Efforts Are Increasing and Penalties Can Be Substantial

Aside from the income tax reporting rules associated with cryptocurrency, the Internal Revenue Service is more adept at detecting potentially unreported income associated with these assets. Going forward, taxpayers are required to specifically report the existence of cryptocurrency on their tax returns. Taxpayers with unpaid balances are similarly required to report the existence of cryptocurrency in collection matters. And those holding cryptocurrency through a foreign bank account or certain types of virtual wallets may be required to file other informational reports, including FBARs (Report of Foreign Bank and Financial Accounts).  

With recent cases involving Coinbase – a large exchange for trading cryptocurrency – the Internal Revenue Service has significant data to identify potential failures to report these transactions. Initiatives announced by the Internal Revenue Service highlight the increase in planned future enforcement. Substantial civil penalties (including failure to file, accuracy-related penalties, and more), as well as criminal penalties (tax evasion, willful failure to file FBARs, and more), can apply to those seeking to circumvent these rules. Fortunately, there are procedures available to mitigate the potential financial cost of missteps for those actively seeking to rectify the situation.

Tax Counsel Can Help You Properly Report Cryptocurrency and Avoid Penalties

If you have any concerns related to cryptocurrency – whether they relate to how to report it, how to address previously unreported gains and losses, or what level of civil and criminal exposure you might have – you should connect with a tax attorney as soon as possible. Working with an experienced lawyer can help to identify the issues, properly address any current or past compliance problems, and explain the different mechanisms for resolving these issues. Turning a blind eye to the problem is not an effective solution. If proactive measures are taken, in many cases, severe penalties can be abated by documenting that reasonable cause exists and/or that any violations of tax and reporting laws were non-willful. Call a tax audit lawyer in Hanover, MD from a firm like Crepeau Mourges to better understand how they can put you on the path to compliance for your cryptocurrency issues.