Disclaimer: We’re wading into the treacherous world of taxes today (with an admittedly U.S.-centric view). Please note that we are not tax advisors and nothing we offer here should be construed as tax advice. We hope that it will help you have a constructive conversation with your personal tax advisor.
Raise your hand if you want to talk about taxes! Ugh. Taxes are one of the least fun topics imaginable. Here, we’ll review some of the key points regarding taxes and cryptoassets. It won’t necessarily be pleasant, but hopefully it will be enlightening and help clear up some confusion.
Have you heard about or seen the movie, The Quiet Place? The premise of the movie is that the world has been taken over by blind monsters who hunt their prey by sound. All remaining humans have to live in absolute silence because if they make even the tiniest bit of noise, the monsters will find them.
To use a grim metaphor, the tax authorities are like the monsters in The Quiet Place. They hunt for the sound of cryptocurrency transactions. And they will pounce on the crypto investors who fail to report their transactions accurately.
The Internal Revenue Service (IRS) knows that vast numbers of cryptocurrency investors aren’t reporting their taxable gains — and that’s why they’re on the hunt.
According to Credit Karma, a service used to file tax returns, only 100 U.S. investors out of the first 250,000 to file with the software in 2018 had reported crypto-related 2017 gains. That’s less than one-half of one percent of filers (0.04%).
If you compare that number (0.04%) to the estimated 7% of Americans owning or trading cryptoassets, it means well over 90% of US-based crypto investors think they can get away with the “silent” strategy: simply not saying anything about their cryptoasset investments and hoping the “monster” (the IRS) doesn’t find them.
But the IRS isn’t fooling around. They may have mostly ignored the cryptocurrency situation when the total market cap of cryptocurrencies was small potatoes. But when the total market cap of the cryptoasset world exploded forty-fold in 2017 (from around $20 billion to $800 billion or so) the IRS sat up and took notice. (They probably also noticed the prominence of crypto millionaires, the Cryptorati, buying the occasional private jet, and the trend of using Lamborghinis as a kind of crypto wealth unit.)
So anyway, as a result of the vertical rise in cryptoasset values in 2017, the IRS got serious in its hunting and tracking capabilities. In addition to setting up a special cryptocurrency unit, the IRS has purchased specialized software, from a company called Chainalysis, that is designed to trace bitcoin movements from one wallet to another.
As a result of that software, the IRS theoretically has the capability of examining cryptocurrency transaction patterns, with further ability to issue a subpoena if it sees something suspicious. Many who believe the IRS can’t find them will be in for a very unpleasant surprise. The IRS has also made inroads in getting the major cryptocurrency exchanges to report crypto transactions above a certain level.
Coinbase, the largest cryptoasset exchange in the United States with more than13 million users, is sending 1099-K forms to customers who complete more than 200 transactions or sell more than $20,000 worth of coin values. Coinbase actively encourages its users to do the right thing and report their transactions. They are telling the IRS what their customers are doing (as they must, by various laws).
The cryptoasset situation is especially tricky because cryptoassets are treated like property rather than currency. As the IRS confirmed in an official statement (bold emphasis ours):
“[digital currency] does not have legal tender status in any jurisdiction… the notice provides that virtual currency is treated as property for U.S. federal tax purposes. General tax principles that apply to property transactions apply to transactions using virtual currency.”
Because cryptoassets are treated as property, there is a taxable capital gains event every time a cryptoasset is sold.
So, if you sell some bitcoin to buy ether, the IRS would not recognize that as a single transaction. They would require the value of the bitcoin to be calculated at the time it is sold, in order to levy a capital gains tax, and then the purchase of ether would be a new transaction.
There are some other strange factors that result from cryptocurrency being treated as property, in the sense that buying something with cryptocurrency is like conducting a property-for-property swap. There are potential sales taxes on purchases made with cryptocurrency as well. We are only scratching the surface of the fine print details in this area.
Tax season is already a horror movie for a certain group of highly unfortunate crypto investors. These are the individuals who generated a large amount of taxable gains in the crypto run-up of 2017, but then accidentally spent the money owed to the IRS instead of withholding it, or else generated large taxable gain obligations when they sold bitcoin and used the proceeds to buy other coins which lost value.
There are reported stories of horrified investors realizing they owe the IRS anywhere from $50,000 to $400,000 or more while no longer having access to the funds (because they were spent or subsequently lost in another transaction that fell in value in the following tax year).
It’s not our place to give complicated advice here (again, you should seek out a certified and competent professional for all matters relating to taxes), but we can lay out a few basic guidelines when it comes to cryptocurrency and taxes:
If you think you might need professional tax preparation assistance, you almost certainly do. The particulars of cryptocurrency tax law are extremely tricky. It is a “wild west” in multiple senses of the phrase, and a competent professional with crypto tax knowledge is your best bet for handling taxes properly.
You can think of capital gains or losses on cryptoassets like capital gains or losses on stocks — except they are treated as property. The capital gains and losses from cryptoasset investing and related transactions are generally reported on Schedule D of the tax form (where other capital gains are recorded).
Keep records for all crypto transactions and be prepared to defend the accuracy of those records. The IRS operates on a “guilty ’til proven innocent” type basis, which means the burden of proof is on the individual they are going after. If the IRS says “We think you owe us $50,000” it is not on them to prove they are right… it is on you to prove they are wrong. Accurate records are a must in terms of dealing with any issues here. If you haven’t been keeping good records so far, do your best to go back to your exchange of record and wallet transactions and get the information together.
Honesty is far and away the best policy. If a U.S. filer makes a mistake on their tax returns but it is seen as an honest mistake and a good faith effort, generally the worst result will be some kind of fine or interest rate penalty (along with collection of the missing amount). If the IRS believes that a tax filer is being willfully untruthful or playing games, on the other hand, the result can be dangerous, as they could crack down hard on any perceived intent to deceive.