Filing taxes on your crypto gains is not an option; it is a requirement under the IRS tax code. Below are several reasons why you should start reporting cryptocurrency on your tax return.
Crypto Tax Question On The Front Of Form 1040
Starting this year, the IRS is asking every american taxpayer whether they received, sold, sent, exchanged, or otherwise acquired any financial interest in any virtual currency during 2020. This question was first introduced in the 2019 Schedule 1. Moving this question from Schedule 1 to the front and center of the Form 1040 indicates how serious the IRS’s looking into this space. Since the crypto question is placed right on the front center of the Form 1040, you are expected to see this. Going forward, it will be extremely hard to make an excuse for not knowing about your crypto tax reporting requirements.
Also note that you are signing the return under penalty and perjury so you have an obligation to answer this question as accurately as possible and file applicable tax forms like Form 8949 and Schedule D.
Crypto Tax Rules Have Been In Place Since 2014
Some people believe that guidance on cryptocurrency taxation is not very obvious. They use this as an excuse for being non compliant. Unfortunately this is not the case.
In the hands of most taxpayers, cryptocurrencies like bitcoin are capital assets. Capital assets are subject to capital gains taxes. Capital gains taxes have been in existence for decades, well before the invention of bitcoin. Besides, in 2014, the IRS took the position that cryptocurrencies are treated as property and all general tax rules applicable to property apply to crypto (Notice 2014-21). Although there are a handful of unique situations where the legacy tax law and existing generic guidance don’t provide direct authority, there is more than enough tax guidance in place for an average cryptocurrency user to properly file their taxes.
Tax Warning Letters
The IRS has been pretty aggressive when it comes to sending tax notices to crypto users who are not reporting crypto holdings. In 2019, the IRS sent out tax notices to 10,000 taxpayers. The IRS sent another round of these letters in August 2020. These letters came in three variations (Letter 6173, Letter 6174 and Letter 6174-A).
It is likely that crypto users will be getting these letters reminding about their crypto tax obligations every year. Dealing with these letters, especially the letter 6173, could be costly and time consuming. Most of that headache can be eliminated by proactively filing your crypto taxes in the first place.
Rewards are in Place to Catch Crypto Tax Evaders
If warning letters weren’t enough, the IRS is offering rewards for companies that help them catch crypto tax evaders. For example, the IRS is offering a $625,000 bounty to anyone who can break Monero and Lightning networks. It also offered a $250,000 contract to a crypto tracing software company to help with ongoing crypto tax audits. Further, the IRS has a close ongoing relationship with crypto compliance focused companies like Chainalysis, Coinbase Analytics and Palantir.
Avoid Tax Audits
The statute of limitation is a legal concept that limits the IRS’s authority to audit your tax returns. Filing a tax return starts your statute of limitation for that year. The general statute of limitation is three years. For example, this means if you file an accurate tax return for the 2019 tax year on April 15th, 2020, the IRS only has time until April 15, 2023 (three years from the date of filing) to audit you, if your return gets picked. After this date, the IRS does not have the authority to audit your 2019 tax year.
With that being said, there are two exceptions to the three year rule. First, if you were to understate your gross income by more than 25%, the statute of limitation is extended to six years. Second, If you did not file any tax return, the statute of limitation never starts so the IRS can come after you at any point in time.
Hence, by filing an accurate crypto tax return you start your three year statute of limitation for that tax year and significantly limit the IRS’s power to audit you after this period ends. This is why filing something is always better than filing nothing. Do not skip filing and give the IRS unlimited time to audit your taxes!
The tax code allows you to deduct your crypto trading losses. If you are a hobbyist investor, you can deduct up to $3,000 of capital losses every year. If you have losses in excess of this amount, the remainder will be carried forward to future tax years. When you have capital gains in future years, you can use these carried forward losses to offset those gains. Also, you can use crypto losses to offset your stock and other capital gains.
If you are considered a trader for tax purposes, there is no cap on deducting capital losses in any given year. You could even deduct your unrealized losses from cryptocurrency gains if you properly make §475(f) tax election.
Clearly, without filing a tax return you can not take advantage of these write offs and the associated benefits.
Disclaimer: this post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.