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Last year's losses on cryptocurrency trading still hurt. But an IRS audit would surely compound the pain. The odds of an audit in any one instance are hard to assess, but it's logical to assume that the IRS will be building expertise in cryptocurrencies, trading platforms, and the global scope of virtual currency trading. The IRS is aware of the explosive growth of cryptocurrency trading over the past five years. Some tax experts expect an increase in IRS inquiries about inaccurate or low-balled reports of gains and losses.
"The IRS is simply trying to beef up enforcement of the law, and they'll likely focus first on cryptocurrency investors who have failed to report, or under-reported, their tax liability on previous income tax returns," says Tyson Cross, founder of Cross Law and a digital asset specialist in Reno, Nevada. "We have not seen any audits of this kind yet, but that will change. The days of the Wild West are over."
Brace yourselves. The 2018 tax losses stemming from significant price declines over the year – 80 to 90 percent in most cases – should prompt cryptocurrency traders to improve their transaction bookkeeping. The silver lining here is that losses incurred, whether from bitcoin or a different digital capital asset, can offset taxes due on capital gains pocketed in the same tax year. In some cases, those capital losses can be used to reduce taxes due on ordinary income. The big takeaway is that virtual currency transactions are taxable by law as property. This rule applies to exchanges of cryptocurrency for cash, goods/services, and other altcoins. If you're not a tax law whiz, all this can be a nasty burden to sort out.
Mike Slack, lead analyst at The Tax Institute at H&R Block says, "We are seeing more customers with cryptocurrency losses coming in for help with their 2018 tax returns. It's hard to know exactly what the IRS is going to do regarding auditing, but bitcoin is an area where we can expect to see more IRS focus because there's a lot of under-reporting." Surely, under-reporting is expected in areas such as cryptocurrency, which is relatively new. "It takes a lot of effort to absorb the knowledge needed to report accurately," says Slack
What to do? First, cryptocurrency investors shouldn't make the mistake of assuming trading losses in 2018 get them off the hook for reporting gains or losses on their individual income tax returns. Taxpayers who do not accurately report the cumulative income tax consequences of every single 2018 virtual currency transaction can be exposed to the risk of an IRS audit. When appropriate, they can be liable for penalties and interest. In more extreme situations, taxpayers could be subject to criminal prosecution for failing to properly report the income tax consequences of virtual currency transactions. Read: possible jail time.
Second, individual investors who do not now use software, off-the-shelf or otherwise, to pull out and pour relevant transaction details into their tax reporting prep files, should consider any number of handy software packages easily obtainable. Just last week, TurboTax said it had integrated the ability to import tax reports from certain exchanges. And businesses like Cointaxes have popped up to help people calculate their crypto-related taxes. (ETHNews does not endorse these or any other services.)
Doesn't the IRS have bigger problems to attack once the government shutdown ends and its examiners get rebooted? Surely, it does. Nonetheless, maintaining reliable transaction records for tax reporting is a worthwhile effort.
Basic Rules of the Road
The following tidbits from the IRS Notice 2014-21 offer a glimpse of some of the complexities involved.
The IRS requires brokers to issue IRS Form 1099-B to function as a record of a taxpayer's gains or losses associated with the brokered sale or trade of certain securities. For federal tax purposes, virtual currency is treated as property, and general tax principles that apply to property transactions apply to virtual currency. When cryptocurrency is sold or exchanged for more or less than what was paid for it, that event produces a capital gain or loss, respectively.
Every single transaction in a given tax year should be tracked by the investor so they are prepared to duel with an agent IRS at the door. The investor will need descriptions of each investment, the purchase date and price, the sale date and price, and associated gains or losses. Taxpayers transfer information from Form 1099-B to Form 8949 to calculate preliminary gains and losses. The calculated result is input onto Schedule D of the tax return. Commissions paid as part of these transactions are excluded.
If the capital losses are smaller than the capital gains, the amount of the loss may be used to reduce the taxable income reported. And there are limits to the amount of capital loss that can be deducted from income each tax year. If the capital loss exceeds the annual maximum limit of $3,000, the difference may be carried over to the following tax year – and each year thereafter – until the investor dies or the loss is extinguished.