FAQs for Taxpayers Holding Cryptocurrencies [And the Five Things to Know About Your Virtual Assets]

Written on March 8, 2022

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The IRS is stepping up enforcement of cryptocurrency reporting to prevent fraud and ensure taxpayers tell the federal government about their income and investment gains from cryptocurrency transactions.

Here’s what taxpayers need to know about holding cryptocurrencies this tax season.

What is Cryptocurrency?

Cryptocurrency is “a digital or virtual currency that is secured by cryptography, which makes it nearly impossible to counterfeit or double-spend.” Cryptocurrencies use blockchain technology to record transactions, creating a highly secure and sometimes anonymous way to move currency between users.

Is Cryptocurrency Taxable?

Yes. For federal tax purposes, virtual currency is treated as property. This means cryptocurrency is taxed in the same way as other assets you own, such as stocks, bonds, mutual funds and ETFs.

Many owners and users of cryptocurrency are unaware that the buying and selling of these currencies create taxable gains under U.S. tax law.

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Can I ask my Employer to Pay Me in Cryptocurrency?

No. Companies cannot legally pay employees wages in cryptocurrency. Currently, the Fair Labor Standards Act requires employers to pay employees in American currency. An employee can personally invest net salary proceeds in cryptocurrency.

How are Cryptocurrencies Reported and Taxed?

Both the IRS and the Financial Crimes Enforcement Network (FinCEN) have identified cryptocurrencies as an area of interest in combating tax fraud and other financial crimes.

Starting in 2020, the IRS revised Form 1040 to include a question regarding cryptocurrencies. This question on the front page of a taxpayer’s federal income tax return asks whether the taxpayer has received, sold, or otherwise acquired a financial interest in any virtual currency.

By placing this question front and center, the IRS indicates that taxpayers cannot claim they did not know they were required to report cryptocurrency transactions. When taxpayers check yes to this question, the IRS will expect the taxpayer to file IRS Form 1040 schedule D — the same form used to report gains and losses from stocks and other equities — with their Form 1040.

Taxpayers who check yes to the cryptocurrency question but don’t report cryptocurrency transactions on their returns can almost certainly expect to be contacted by the IRS follow up and possibly audited.

Yet self-reporting isn’t the IRS’s only method for going after unreported cryptocurrency gains. FinCEN is currently working on regulations that will make it easier for the federal government to track cryptocurrencies held in private wallets and trading platforms.

For example, sending a large amount of cryptocurrency to a private wallet would require a person to inform the government that they are the wallet’s owner.

Cryptocurrency trading platforms, such as Coinbase and other major exchanges will likely be required to issue 1099 forms to account holders in the near future. Individuals and organizations that don’t comply with these new reporting requirements could face significant tax penalties and potential criminal and civil penalties for perjury or tax evasion.

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How Does the IRS Investigate Unreported Cryptocurrency Earnings?

The IRS’s recent approach to cryptocurrency parallels how it responded to hidden income and assets in foreign bank accounts.

When the IRS became aware that U.S. taxpayers were hiding assets and earnings in foreign bank accounts without reporting them, a question was added to tax returns, requiring taxpayers to disclose whether they have a financial interest in a foreign account under penalty of perjury.

The IRS then utilized various methods, including significant penalties against the foreign banks and their officers, to force financial institutions in other countries to report the activities of U.S. taxpayers with whom they were doing business.

Instead of paying the significant penalties or facing prosecution, these institutions turned over the names and account information of U.S. taxpayers to the IRS. Having all the information needed, the IRS then began auditing U.S. taxpayers, many of whom were convicted criminally.

The IRS is taking a similar approach to rooting out cryptocurrency owners.

What Do Cryptocurrency Holders Need to Know to Fully Comply With Tax Law?

There are a few critical items that U.S. taxpayers who hold cryptocurrencies should keep in mind in the immediate future to ensure that they comply with tax law and are informed of the IRS’s activity regarding virtual assets.

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  1. Taxpayers should be aware of and prepared to accurately answer the question about cryptocurrencies on their Form 1040 federal income tax returns.
  1. The COVID-19 pandemic may be straining IRS resources, but cryptocurrency enforcement is still a top priority. The IRS uses the “John Doe” summons to target unknown taxpayers.

A “John Doe” summons allows the IRS, with court approval, to compel information from a third party (such as a cryptocurrency exchange) regarding a taxpayer not identified by name in the summons. The documents the IRS seeks from the exchanges include account registration records, account-related correspondence, records of account activity and more.

  1. The IRS recently announced it made changes to Form 14457, which permits taxpayers who may face criminal prosecution for willful violations of tax law to voluntarily disclose information to the IRS that they failed to disclose previously.
  2. Cryptocurrency owners should begin tracking and reporting gains and losses now. While some cryptocurrency platforms allow users to print out a report of their annual transactions, people who have crypto across several wallets and exchanges may want to consider software to track transactions across all platforms.
  1. Taxpayers may need to amend their prior-year tax returns if they haven’t reported cryptocurrencies previously.

For more information about how cryptocurrencies are taxed or to learn more about how to move forward with reporting your virtual assets, contact your Warren Averett advisor or ask a member of our team to reach out to you.

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This article was originally published on July 15, 2020 and most recently updated on March 8, 2022.

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