The IRS is currently working on guidelines for cryptocurrencies to help prevent fraud and to ensure tax laws can be enforced in the United States. Here’s what taxpayers need to know.
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 are often built using blockchain cryptography, which creates a highly secure, but mostly anonymous, way to move currency between users.
Is Cryptocurrency Taxable?
Yes. For federal tax purposes, virtual currency is treated as property. General tax principles applicable to property transactions apply to transactions using virtual currency.
Although cryptocurrencies are often used by people wanting to avoid tax liabilities or other legal issues, the buying and selling of these currencies creates gains that are taxable under U.S. tax law.
If Cryptocurrencies are Held Anonymously, How Are They Reported to the IRS?
Because of the anonymous nature of virtual currencies, they are often used in criminal enterprise. And recently, the IRS has identified cryptocurrencies as a new area of perceived tax abuse.
The 2019 Form 1040 includes a question regarding cryptocurrencies, in which the taxpayer must declare any involvement in cryptocurrency transactions and declare any gains or losses on the currencies under penalty of perjury.
Taxpayers can trade in cryptocurrency like stocks and mutual funds, and some individuals have made significant gains on transactions that have previously gone unreported. And while the recipients of each transaction are anonymous, blockchain transactions are recorded on a public ledger, which means that the IRS has a tremendous starting point with identifying where taxable income is in any public blockchain encryption.
The IRS sent requests for proposals to specific technology vendors to assist in auditing the blockchain transactions. As they build this system, there will be many individuals who will find themselves facing significant tax penalties and potential criminal and civil penalties for perjury or tax evasion.
What Should Taxpayers Know About the Way the IRS is Approaching the Investigation of Unreported Cryptocurrency Earnings?
The IRS’s recent approach to cryptocurrency parallels how it has previously responded to hidden income and assets in foreign bank accounts.
Similar to the approach to cryptocurrency, 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, which needed to be answered under penalty of perjury, that asked if taxpayers had foreign accounts.
The IRS then utilized various methods, including significant penalties against the foreign banks and their officers, to force these institutions in other countries to report activities of U.S. taxpayers with whom they were doing business. These institutions, instead of paying the significant penalties or facing prosecution, turned over the names and account information of U.S. taxpayers to the IRS. The IRS, having all the information needed, then began auditing U.S. taxpayers, many of whom were convicted criminally.
The lessons learned have significant implications for cryptocurrency owners.
What do Cryptocurrency Holders Need to Know Right Now?
There are a few key items that U.S. taxpayers who hold cryptocurrencies should keep in mind in the immediate future to ensure that they are in compliance with tax law and informed of the IRS’s activity regarding virtual assets:
- Taxpayers should be aware of and prepared to accurately answer the question about cryptocurrencies on their 2019 tax returns.
- In 2019, the IRS has sent letters to 10,000 crypto traders and asked that they verify that they filed their taxes due on crypto gains and losses correctly, or amend their tax filings under penalty of perjury.
- The coronavirus pandemic may have slowed down the IRS in this regard, but it is still moving forward with a cryptocurrency initiative. The IRS’s task force regarding cryptocurrency will likely come out with guidelines in the near future. Taxpayers who hold cryptocurrencies should stay informed concerning recent guidance, as well as the expected new developments to follow.
- Cryptocurrency owners should begin to learn how to record and report any gains and losses now.
- These taxpayers may need to amend their 2019 tax returns or other past returns if they haven’t reported cryptocurrencies previously.
Cryptocurrency owners who have significant virtual assets should discuss their reporting requirements with an accountant who is experienced in blockchain technology and up to date on the IRS’s task forces and legal requirements.
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.