The IRS (Internal Revenue Service) has been slower to audit tax returns in recent years due to the COVID-19 pandemic, but there are signs that it’s stepping up its enforcement actions related to cryptocurrencies. In addition to a new question at the top of Form 1040, the agency has issued several warning letters and sought to hire crypto experts to track down crypto tax evaders via crypto tax audits.
Let’s take a look at some of the most common IRS crypto tax audit triggers—including those that relate to cryptocurrency tax—and how to accurately report crypto transactions on your tax returns.
The Most Common IRS Crypto Audit Triggers To Look Out For
The IRS has audited about 0.6% of personal returns and 0.97% of all corporate returns between 2010 and 2018. Last year, the agency audited 771,095 tax returns that resulted in nearly $17.3 billion in recommended additional tax. The absolute numbers may be low, but there are a number of factors that can dramatically increase your relative risk.
IRS Compliance Activity in 2019 – Source: IRS
The relative risk of a tax audit can increase for several reasons:
- High levels of income. Most audited tax returns are for taxpayers that earn $500,000 or more each year, whereas income between $25,000 and $200,000 was generally safe. High-earning crypto traders and investors could be more likely to experience a crypto tax audit.
- Unreported income. Crypto exchanges typically send 1099-B or 1099-K forms to clients that exceed certain transaction thresholds. Since the IRS receives copies of these, a failure to report income triggers the IRS’ Automated Under reporter Program.
- Itemized deductions. The IRS assumes that most people live within their means. If you only make $50,000 per year and start claiming a mortgage interest deduction on a $1 million mortgage, the IRS could start to ask some questions.
- International assets. Foreign assets valued at more than $50,000 must be reported to the IRS along with all accounts with balances over $10,000. If you hold crypto assets in these amounts overseas, you could face greater IRS scrutiny.
- Suspicious Deductions. The IRS scrutinizes taxpayers that take-home office or business vehicle deductions to ensure that they aren’t really for personal use. If you trade crypto and make these deductions, it could increase the relative risk of a crypto tax audit.
- Hobbies as a business. There are a lot of tax rules designed to separate hobbies from businesses. Crypto investors looking to diversify into other assets, such as farms, may not be able to claim those assets as businesses without added scrutiny.
- Mathematical mistakes. The IRS automatically checks tax returns for accuracy, so it’s important to avoid any basic mathematical mistakes. If you have a lot of crypto transactions, you should ensure the math is correct when aggregating them.
- Large spending or deposits. The IRS requires businesses to notify them when large cash transactions of more than $10,000 take place. If you make a $10,000 cash transaction with crypto proceeds, you could invite more IRS scrutiny.
- Missing documents. The IRS considers mismatched documents as the most common causes of auto-trigerring a crypto tax audit.
- Self employed. Make sure you save the receipts of business expenses, such as home-office expenses, transportation expenses as well as business meals (yes, you read it right) to help at the time of crypto tax audits.
The IRS identifies potential issues using its Discriminant Information Function (DIF) program that detects anomalies in tax returns. Every tax return is checked for duplicate information, deductions, and credits that don’t apply, and returns are compared to other taxpayers that earn approximately the same income to find outliers.
Crypto Taxes: Ensure Crypto Tax Accuracy Without Overpaying
Cryptocurrency traders and investors must walk a fine line between ensuring accurate calculations and avoiding the tendency to overpay taxes. For example, Coinbase sent out a 1099-K form in the past that omitted cost basis information and led some users to overpay and many others failed to deduct fees and other costs from their gains.
The best way to ensure tax accuracy is to automate the calculations using crypto tax software. ZenLedger Crypto Tax Software automatically aggregates transactions across your wallets and exchanges, calculates the cost basis and net gain/loss and auto-fills popular IRS forms. If you use TurboTax, you can leverage a built-in integration to handle all of the taxes for you with a few clicks. Sign up and get started for free!
If you don’t use crypto tax software, there are a few things to keep in mind:
- Don’t forget to calculate cost basis. Form 1099-K tells you the total value of crypto assets received during the year whereas Form 1099-B provides a list of transactions with the cost basis (where applicable). In both cases, you should ensure that you include an accurate cost basis for transactions to avoid overpaying taxes.
- Don’t forget to look across wallets and exchanges. Most exchanges provide cost basis information for transactions on their exchange, but if you use multiple wallets or exchanges, the cost basis may depend on assets held in those accounts. Using all of your wallets and exchanges can also help facilitate long-term capital gains tax rates.
- Don’t forget to account for fees. Trading fees are fully deductible from the sale price of a crypto asset. While there are a few different ways to handle transfer fees, the simplest way is to reduce your holdings by the transfer fee amount and keep the value the same, but it’s best to ask an accountant for a professional opinion.
In addition to using crypto tax software, it’s a good idea to work with a Certified Public Accountant (CPA) and financial advisors with crypto experience and knowledge of tax law. These professionals can help optimize your overall portfolio to reduce your tax burden, as well as ensure that you’re maximizing any valid deductions related to your crypto activities.
IRS Crypto Tax Audit: Always Be Prepared for an Audit
Taxpayers should be prepared to provide the IRS with everything they need in the event of an audit in order to avoid potential fines and penalties.
Your tax advisor or counsel can prepare an audit dossier for you and perform a double-check on your previous returns.
The dossier will include all the data and papers directly linked to your return. Also, the binder will help you feel confident and prepared to maintain the position on your return during the audit.
The basic requirement will be to present the buy and sell price of each crypto transaction. The prices will rely on when and how you bought the crypto asset, when it was sold, and more. When you are organizing your records, remember the following:
- All records, transactions, and receipts are documented by your crypto exchange, blockchain, or broker. If you paid for the assets electronically, keep the record such as EFTs and wire transfers.
- In an event of crypto faucets, hard forks, airdrops, and tipping try and record as many details as you can related to the transactions.
- It is important that you maintain the records of buying or receiving payments for goods and services. Also, maintain the records of the price at the time of disposal of the assets.
- Prepare a list of blockchain addresses owned or controlled by you and banks linked to user IDs, and a spreadsheet of all crypto exchanges, account numbers, and IP addresses related to these platforms.
- Documents related to lending or utilization of cryptocurrency as a loan’s collateral.
This in-depth preparation can also highlight weak areas that can be addressed proactively. It can also show you how to use your digital assets for accounts and audit efficiency.
You should also be prepared to provide the following information about every transaction:
- The date and time of virtual currency purchases.
- The cost basis and fair market value at the time of acquisition.
- The date and time that virtual currency was sold, exchanged, or otherwise disposed of.
- The fair market value at the time of sale, exchange, or disposition and the amount of money or the fair market value of property received.
- An explanation of the method used to compute cost basis.
If the IRS finds any irregularities, you may also be asked for all correspondence with all counterparties to virtual currency transactions and other information.
Is there a way to correct the mistake before being audited? While currently there is no special crypto-only voluntary disclosure regime, the taxpayers can comply where errors are found. You can consult your tax layers to discuss crypto investments and transactions.
Let’s take an example to understand its importance. Let’s say you bought a stock in a company, you generally would not use small portions of it to make several thousand transactions a year. That’s what happens with cryptocurrency. People are eager to use cryptocurrency to buy coffee every day. It is not efficient from an accounting perspective to use crypto tokens to buy goods and services every day. Unless the record-keeping is immaculate and records every transaction. In the future, innovative web-based tools are going to make the record-keeping of such micro-transactions easier.
These records should be maintained for a minimum of five years since the IRS can audit tax returns in the past; however, it’s generally a good idea to keep them indefinitely in virtual form since the IRS is allowed to look back further than five years in some cases.
Watch your Social Media Postings
IRS auditors have various methods to establish a case against a taxpayer. These methods can include a run-of-the-mill internet search revealing plenty of interesting information about the taxpayer. This information can color an agent’s opinion about the taxpayer and the case.
In short, watch what you post online. In a recent Coinbase case, the IRS found out about some taxpayers who openly acknowledged that they were interested in investing in Bitcoin just to avoid tax reporting. Needless to say, posting such sentiments on your social media can draw additional scrutiny and heavy penalty rates.
While social media is an easy way to find tax avoidance rhetoric, emails and letters also convey the same sentiment. Be mindful of what you say and to whom you say it.
The Bottom Line
The IRS may have been slow to audit returns over the past couple of years, but the agency has stepped up its enforcement of cryptocurrencies. By keeping audit risks in mind and accurately recording your transactions, you can minimize your IRS audit risks. ZenLedger makes it easy to ensure accuracy and minimize your tax burden. Try it today!
More resources to explore:
- How to Report Crypto Taxes: A Step by Step Guide
- Crypto Tax Calculator: Calculate Your Tax Obligation in Seconds
- Non-Fungible Tokens (NFTs) & Crypto Taxes
Disclaimer: This material has been prepared for informational purposes only and is not intended to provide, tax, legal or financial advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.