The crypto market briefly surpassed $3 trillion in total value before the mid-2022 plunge. While many investors are harvesting their tax losses, the IRS secured $80 billion in new funding from the Inflation Reduction Act that it plans to use to close an estimated $600 billion tax gap. And much of these efforts will likely focus on crypto-related enforcement.
Let's take a closer look at how the IRS' new $80 billion in funding could affect your audit risk as a crypto enthusiast, trader, or investor.
The Inflation Reduction Act provides $80 billion in funding for the IRS to close the $600 billion tax gap – and the agency will spend a lot of these resources on crypto-related enforcement.
The IRS Gets $80 Billion
The Inflation Reduction Act will give the IRS $80 billion over the next decade to update its decades-old computer systems, improve customer service, and above all else, step up enforcement. In particular, the agency has its eyes set on the $600 billion in taxes that go unpaid each year – or the so-called "tax gap" that includes unreported crypto transactions.
Today, most IRS audits target lower-income families that receive the Earned Income Tax Credit (EITC). More complex cases involving the wealthy tend to go under the radar thanks to the agency losing about 30% of its workforce since 2010. The new funding promises to shift enforcement to more affluent individuals with more complex cases.
Ultimately, the Congressional Budget Office hopes the $80 billion investment will help recoup some $203.7 billion in revenue between 2022 and 2031 through stepped-up enforcement. After years of falling audit rates, these trends could spell a significant increase in enforcement, as the agency hires around 87,000 new agents to analyze returns and conduct audits.
Why Crypto is an IRS Target
The IRS has a tenuous relationship with cryptocurrencies. After issuing basic guidance in 2014, the agency launched a campaign targeting cryptocurrencies in 2018 and sent warning letters to thousands of taxpayers in 2019. In March 2021, the agency launched "Operation Hidden Treasure" to identify taxpayers omitting cryptocurrency from their tax returns.
IRS Commissioner Rettig told lawmakers in April 2021 that cryptocurrency tax underpayment is a key contributor to the tax gap, suggesting that it’s a priority for the agency. Since then, it has been issuing John Doe Summons to cryptocurrency exchanges to uncover the identities of U.S. taxpayers that it suspects of underreporting crypto income.
The IRS will likely continue to double down on crypto tax enforcement with its new budget, focusing on high earners that it believes omit cryptocurrency income on their tax returns. In particular, the agency will have the latitude to bolster its crypto-focused ranks while investing in new technologies to better track blockchain transactions.
Crypto Tax Reporting Changes
The IRS added a cryptocurrency question to Form 1040 in 2019, forcing every taxpayer to certify under penalty of perjury if they received, sold, sent, exchanged, or otherwise acquired any cryptocurrency. A failure to correctly answer the question could be punishable by up to five years in prison and a fine of up to $100,000 if convicted.
In a draft of the new 2022 Form 1040, the question changes to: "At any time during 2022, did you: (a) receive (as a reward, award, or compensation); or (b) sell, exchange, gift, or otherwise dispose of a digital asset (or a financial interest in a digital asset)? (See instructions.)" The move is presumably to encompass digital assets beyond cryptocurrency.
The Infrastructure Act brought cryptocurrencies under the "broker" definition and subjected them to the IRS information reporting regime. Beginning in 2023, cryptocurrency exchanges will have to register their customers' annual crypto gains and losses to the IRS using the new Form 1099-DA, enabling the agency to track discrepancies better.
Unfortunately, the decentralized nature of cryptocurrencies complicates tax reporting. For example, DeFi exchanges cannot provide Form 1099s because they don't collect user information by design. In addition, many users also transfer assets between exchanges and wallets, which makes it difficult for exchanges to compute the cost basis accurately.
Protecting Yourself in an Audit
The IRS' expanded focus on cryptocurrencies means that traders and investors should keep excellent records and ensure they're paying the correct amount of tax on time. The easiest way to do that is using crypto tax software that automatically aggregates transactions across all of your accounts to accurately compute cost basis and capital gains.
ZenLedger offers one of the most comprehensive crypto tax solutions, supporting over 400 exchanges, including 100+ DeFi protocols and 10+ NFT platforms. Unlike many other crypto tax solutions, the platform also provides Grand Unified Accounting, making it easy to see your entire transaction history across all accounts to defend against an audit.
In addition to using crypto tax software, individuals with complex taxes should consider using a crypto-savvy accountant and financial advisor. These professionals can help identify ways to harvest tax losses (particularly following the crypto winter) and coordinate different types of financial assets to minimize the taxes you owe.
The Bottom Line
The Inflation Reduction Act provides the IRS with $80 billion in funding over the next five years to close the tax gap. While the increase in funding could help prosecute tax dodgers, the crypto industry could see a crackdown on underreported income. And in some cases, the agency's poor guidance could put innocent taxpayers in the crosshairs.
If you trade cryptocurrencies, ZenLedger can help aggregate transactions across wallets and exchanges, compute capital gains or losses, and auto-fill the IRS forms you need.