There are few phrases that strike as much fear into your heart as “IRS audit,” and as a cryptocurrency investor, you might be at additional risk. Fortunately, there are ways to mitigate your risk of being selected. Here’s a look at how to help your chances of staying off the government’s radar, and what happens in the event you are selected.
What Is An IRS Audit—And Who’s At Risk?
First, let’s clarify how an IRS audit happens: It results from a request to delve further into your financial information to make sure that your tax return complies with all tax laws. While some audits occur as a result of random selection, other returns are selected because of factors that seem to indicate something is amiss. Common red flags include:
- Not reporting all taxable income so there is a mismatch with what the IRS believes you were paid
- Running your own business and claiming income that doesn’t seem to match
- Claiming lots of deductions
- And, it seems, using cryptocurrencies.
Are You Already In the IRS’ Sight?
If you buy and sell cryptocurrencies, the IRS may already have its eye on you. In fact, in March 2018, the agency sent out an official reminder that taxpayers are obligated to report virtual currency transactions. Always use any Crypto tax service to calculate your Crypto Taxes and Accounting.And the stakes are high: The IRS states clearly that taxpayers who do not report tax events related to their cryptocurrencies can be audited, and will be liable for penalties and interest. The notice also warned that in extreme situations, taxpayers could be subject to criminal prosecution if they are convicted of filing a false return, and be subject to prison time of up to three years and a hefty fine of up to $250,000.
How to Avoid A Tax Audit and Penalties
The short answer: Pay your Crypto Taxes and Accounting. Of course, that is sometimes easier said than done, because the accounting can indeed be complex—more on that later.The key thing to note is that for tax purposes, virtual currency is treated as “property.” That means that all the laws that apply to accounting for property, including classifying any gains as either long-term or short-term, apply to cryptocurrency. (This post explains the difference in more detail.) And if you were paid in cryptocurrency for anything, you must deduct the appropriate taxes.
Why Paying Your Taxes Might Not Be Simple Math
So if you sold cryptocurrency for $10, you made $10, right? Not so fast….one reason this gets complicated is because you have to know your “cost basis”—or the price you paid initially—to calculate the appropriate gains and thus taxes. However, unlike just looking up the purchase price of a stock, it can be more difficult to calculate since there are so many exchanges and the exchange price can differ from one platform to another.In addition, if someone gifts you cryptocurrency, you need to report their cost basis. One option is to use a weighted index.There are a lot of different factors to consider, and it’s not always as straightforward as it seems—if you’re confused, an accounting professional can offer you some guidance.Finally the money you make mining coins can be complicated too; it depends whether you were mining your own coins or someone was paying you to do it and therefore you are an “independent contractor,” and thus need to report self-employment taxes.If you are mining your own coins, you count the value of the cryptocurrency on the day it came into your account as income. And if you’re getting paid for your mining work in cryptocurrency, then use the value when you mined it as the cost basis.Of course, this brief summary doesn’t cover every scenario, but it gives you a place to start—and certainly emphasizes the need for stellar records.
Looking Ahead: Make Next Year Easier
In order to alleviate the risk of audit going forward, it’s important to make sure your cryptocurrency records are as organized as possible. Here are some steps to take that will make it easier to do your cryptocurrency taxes going forward.
- Record your purchases.
The easiest way to track your cost basis for the future is to keep track of your transactions today. If you’re buying and selling coins, track the date and amounts sold so it will be easy to reference next year…and so that you have clear records in the event that you are audited.
- Track your spending.
Any time you use virtual currency as a form of payment, you are triggering an event that has to be recorded and reported, since the IRS considers cryptocurrency an asset. Although it can be annoying to track every restaurant meal or latte, it will be necessary for effective records, and you can consider it a personal finance exercise as well.
- Seek help if you need to.
The IRS doesn’t mess around, so neither should you. Just because accounting for cryptocurrencies is challenging doesn’t mean that you should look the other way as that can make you a prime candidate for an IRS audit. If you’re unsure how to track and record your cryptocurrency in order to avoid an IRS audit, consider consulting a knowledgeable tax professional or look into software that will make the job easier. ZenLedger can help you understand your tax obligations.