Usually, the Internal Revenue Service (IRS) expects its taxpayers to voluntarily report their taxable income for the financial year as per the comprehensive set of tax laws created by the IRS. If a taxpayer fails to report their crypto taxes, they can face hefty penalties, and therefore, it is recommended to proactively and honestly report taxes to the tax authority. Nonetheless, a great number of taxpayers fail to report their crypto transactions, placing them in the reporting gray zone.
Having said that, it must be understood that the taxpayer is not always in the wrong as a few may just not know that they need to report their transactions, and sometimes may simply not know what exactly to report. So, how does the IRS know you owe them crypto taxes? Can the IRS track crypto? The short answer is yes; but how does the IRS track crypto? Read on to find out.
What Makes Crypto Taxable?
Cryptocurrencies are taxable because they are considered property by the Internal Revenue Service (IRS) in the United States. This means that any gains or losses from buying, selling, or trading cryptocurrencies are subject to capital gains tax.
When a person buys a cryptocurrency, they are essentially exchanging one asset for another, and the value of the new asset is determined by the market. If the value of the new asset increases and the person sells it, they will realize a capital gain, which is taxable. On the other hand, if the value of the new asset decreases and the person sells it, they will realize a capital loss, which can be used to offset other capital gains or up to $3,000 of ordinary income each year.
In 2014, despite this classification, only a few taxpayers were reporting their crypto transactions to the IRS. So much so, that during 2013 and 2015, only a few hundred taxpayers reported their crypto transactions.
Thus, in an attempt to impose cryptocurrency tax laws, in 2019, the IRS mailed over 10,000 letters to taxpayers who might have missed the tax filing deadline. Additionally, the tax collection agency added an extra question on Form Schedule 1 directly asking taxpayers if they made crypto transactions in the current financial year.
The question on the form asked the taxpayer whether they—at any point throughout 2019—sold, received, exchanged, sent, or earned interest in cryptocurrency. Later the IRS shifted the question from Form Schedule 1 to Form 1040 used by taxpayers to report their yearly income tax return.
So, How Does the IRS Track Crypto Transactions?
The IRS has been working to develop a system for tracking crypto transactions and ensuring that individuals and businesses are paying the correct amount of taxes on these investments.
Here are some ways that the IRS tracks crypto transactions:
1. Third-Party Reporting
One of the primary ways that the IRS tracks crypto transactions is through third-party reporting. This includes exchanges and other platforms that facilitate the buying and selling of cryptocurrencies. These platforms are required to provide the IRS with information on their users’ transactions, including the amounts and the parties involved.
2. Blockchain Analysis
The blockchain is a public ledger that records all crypto transactions. While the identities of the parties involved are typically anonymous, the transactions themselves are visible. The IRS has partnered with companies that specialize in blockchain analysis to track cryptocurrency transactions on the blockchain. These companies use advanced software to analyze and trace transactions, allowing the IRS to identify patterns and track down individuals who may be engaging in tax evasion.
3. John Doe Summons
In some cases, the IRS may issue a John Doe summons to cryptocurrency exchanges and other platforms. This allows the agency to obtain information on all users who meet certain criteria, such as those who have conducted a certain number of transactions or exceeded a certain dollar amount in transactions.
The IRS is taking a proactive approach to tracking cryptocurrency transactions and ensuring that taxpayers are properly reporting and paying taxes on these transactions. As the use of cryptocurrencies continues to grow, it is likely that the IRS will continue to develop new tools and regulations to ensure compliance with tax laws.
Subpoenas as a Method to Monitor Crypto
Subpoenas are legal instruments used by government agencies, including the IRS, to obtain information relevant to an investigation. In the context of crypto transactions, the IRS may use subpoenas to obtain information from cryptocurrency exchanges, financial institutions, and other entities that possess information about users’ crypto transactions.
This method is used by the IRS to track down tax evaders who engage in crypto transactions and fail to report them accurately. The subpoenas can be used to obtain information such as user account details, transaction history, and other relevant data that can be used to investigate and prosecute individuals who use crypto for illegal or non-compliant purposes.
In recent years, several exchanges have received several subpoenas directing them to reveal some of the user accounts. For instance, Coinbase was asked by the IRS to reveal information of approx. 13,000 accounts including name, taxpayer identification number, address, birth date, transaction logs, account activity records, all account statements or invoices. In the same way, the IRS has ordered other exchanges such as Circle, Kraken, and Bitstamp to release U.S. taxpayer information used on the exchange.
So, can the IRS track crypto with these subpoenas? Yes, the IRS can determine how often the U.S. taxpayers engaged in cryptocurrency transactions and how many of them went unreported. Even though issuing subpoenas to each exchange can be time-consuming, it is a highly effective way to identify non-compliant taxpayers.
To Wrap it Up
The IRS is taking active measures to ensure that every taxpayer is paying what they owe to the tax collection agency. Can the IRS track crypto efficiently? Maybe, but since the agency has ramped up its efforts to impose tax laws in the crypto space, it has also begun consulting with several blockchain companies to remain in the lead. These blockchain companies are helping the IRS with emerging technology such as machine learning, pattern recognition, and data analysis to identify non-compliant taxpayers. Thus, the IRS is all set to become fully equipped with tools that deal with suspicious activities across different exchanges and blockchains.