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Investors Beware: The IRS Chases After Crypto Profits

Investors Beware: The IRS Chases After Crypto Profits

As cryptocurrencies such as Bitcoin, Ethereum, and Dogecoin go mainstream, the Internal Revenue Service (IRS) is cracking down on American taxpayers who haven't declared their crypto assets or paid taxes on them. 

If you want to avoid a tax mess, you need to declare your crypto assets and crypto-sourced earnings to the IRS. Failure to report crypto transactions on your tax return could result in hefty penalties, audits, and possible criminal investigations.

To ensure that people are complying with tax laws, the IRS has moved a question to the top of the tax return: “At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”

IRS sets its sights on crypto exchanges

To ferret out tax cheats, the IRS has issued summonses to payments company Circle and the crypto exchange Kraken to turn over a broad array of customer information, including names, phone numbers, email addresses, dates of birth, and taxpayer ID numbers.

While brokerage firms are obligated to report stock transactions and other information to the IRS, crypto exchanges aren't required to do the same. This lack of transparency makes cryptocurrencies a potential hotbed for tax evasion and criminal activity.

The searches are part of the IRS's campaign to fight crypto tax evasion. Apart from issuing summonses, the tax agency is also working on new regulations to require crypto transaction reporting for financial firms.

In 2020, the Treasury Department also amended FBAR rules to include crypto assets. If you hold more than $10,000 of cryptocurrencies offshore, you may also be required to file a FinCEN Form 114, also known as a Foreign Bank and Financial Accounts Report.

Do you pay taxes on investments

The rules surrounding crypto can be confusing. Here are some of the key points you need to remember.

The IRS considers cryptocurrencies as property, and tax principles applicable to property transactions should apply to crypto transactions as well. This puts them in the same category as other investment property such as real estate, shares, and bonds.

Capital gain tax on cryptocurrency is relatively straightforward. If you sell a crypto asset after holding it for more than a year, the profit is considered long-term capital gain and therefore taxed at lower rates. However, if the holding period is one year or less, such as in day trading, your capital gain is short-term and the federal income tax rate kicks in.

Losses on your crypto assets can be used to offset taxable capital gains on other investments, including up to $3,000 of ordinary income. Any unused losses are carried forward to future filings.

If you have provided someone with a service and that person pays you with virtual currency, that payment is considered ordinary income. Whether the payment is considered self-employment income or a wage depends on the employment relationship.

Virtual currency received as a gift is not considered income until you dispose of the crypto asset.

When do you need to pay taxes

Since property rules apply to crypto transactions, sales and exchanges are taxable. If you swapped one cryptocurrency for another, you likely have a capital gain or loss on the transaction. Similarly, if you paid for goods and services with cryptocurrency, the transfer is taxable.

With the IRS keeping a close eye on crypto investments, it's important that you comply with federal tax laws to avoid fines and penalties. If you're wondering how to report cryptocurrency on taxes, talk to a tax expert, we are here to help.

Ines Zemelman, EA
Founder of TFX