The IRS began asking about cryptocurrency transactions on tax returns in 2019. This seemingly simple yes-or-no question has significant implications for taxpayers who own cryptocurrencies like Bitcoin and Ethereum. Understanding why the IRS added this question can help cryptocurrency owners properly report related taxable events and avoid penalties for non-compliance.
What is Cryptocurrency?
Cryptocurrency is a type of virtual currency that uses cryptography to secure transactions. Cryptocurrencies operate independently of central banks and are not issued by governments. Some of the most well-known cryptocurrencies include Bitcoin, Ethereum, Litecoin, and Ripple.
Unlike traditional currencies like the U.S. dollar, cryptocurrencies exist entirely online. Transactions are recorded on a decentralized public ledger called the blockchain. Units of cryptocurrency are created through a process called mining, where individuals use specialized computing hardware to verify blockchain transactions.
The values of cryptocurrencies fluctuate frequently, often wildly, based on supply and demand. Major exchanges like Coinbase allow cryptocurrencies to be easily bought, sold, and traded for traditional currencies like the dollar.
Why Did the IRS Add the Cryptocurrency Question?
The IRS added the cryptocurrency question to Form 1040 to close the tax gap on cryptocurrency capital gains. Prior to 2019, taxpayers were not explicitly asked about cryptocurrency. However, they still had to report any related capital gains, or risk penalties and interest if caught by the IRS.
By adding the direct question, the IRS makes it harder for taxpayers to play dumb. It also serves as an educational reminder about the tax rules surrounding virtual currencies.
The IRS treats cryptocurrencies as property for tax purposes. This means taxpayers must calculate capital gains and losses when they:
- Sell cryptocurrency for fiat currency like USD
- Trade one cryptocurrency for another
- Use cryptocurrency to purchase goods or services
These taxable events must be reported even if the taxpayer did not receive a tax form like a 1099-B. Failing to report cryptocurrency transactions is considered tax evasion.
How Does the IRS Know if You Bought Cryptocurrency?
The IRS has multiple methods for detecting unreported cryptocurrency activity:
1. Subpoenas for Exchange Records
Cryptocurrency exchanges like Coinbase and Gemini must maintain transaction records for tax and anti-money laundering purposes. The IRS can (and does) subpoena these records to look for discrepancies on taxpayers’ returns.
For example, if you transferred $50,000 from your bank to Coinbase and bought cryptocurrency, then the IRS would expect you to have capital gains/losses to report. But if you do not report any such activity after answering “no” on the question, then your return is flagged for audit.
2. Third-Party Reporting Requirements
BROKER X crypto exchanges are required to issue 1099-B tax forms to users who sold cryptocurrency that resulted in a capital gain. Other third-party settlement companies like PayPal must also report payments received in cryptocurrency.
Receiving one of these 1099 forms means the IRS knows you sold cryptocurrency. Omitting it from your tax return will trigger an automatic audit.
3. Software Tools and Blockchain Analysis
IRS criminal investigation divisions utilize software tools to analyze the blockchain. This can identify clusters of cryptocurrency wallets and track transactions to/from wallets controlled by a single entity.
Cluster analysis makes it possible to see large flows of crypto that were not reported properly or to connect wallets back to individual taxpayers.
Penalties for Not Reporting Cryptocurrency
Intentionally failing to report income from cryptocurrency transactions could constitute tax evasion or filing a false tax return. Both civil and criminal penalties may apply in such cases.
On the civil side, the IRS can assess penalties of up to 75% of the unpaid tax plus interest compounded daily. Criminal penalties can include fines up to $250,000 and imprisonment up to 5 years.
Even lacking willful intent, failing to report cryptocurrency transactions can still incur:
- 20% accuracy penalty on the unpaid tax
- Failure to file penalty of 5% per month of the unpaid tax up to 25%
- Failure to pay penalty of 0.5% per month of the unpaid tax up to 25%
Properly answering the cryptocurrency question helps avoid these penalties. Taxpayers should truthfully disclose all taxable cryptocurrency transactions.
How to Report Cryptocurrency Transactions
If you check “Yes” for the cryptocurrency question, you must also file Form 8949 to calculate capital gains and losses. Complete one Form 8949 for each exchange you use.
List each taxable transaction on Form 8949, including:
- Date sold or exchanged
- Proceeds (fair market value in USD)
- Cost basis
- Gain/loss
The totals carry over to Schedule D to report on Form 1040. You must file Form 8949 even if you had no net gain/loss.
Consider using cryptocurrency tax software to automatically import trading history and generate required tax reports. This can save considerable time and ensure you do not miss any transactions.
Should You Amend a Prior Return?
If you failed to report past cryptocurrency transactions, consider amending previous tax returns. The statute of limitations for amending a return is 3 years.
File Form 1040X to amend a return and report previously unreported crypto gains/losses. This will reduce penalties and interest if you are audited.
You may have to amend multiple prior year returns if you traded actively before cryptocurrency reporting requirements existed. Work backwards year-by-year and report transactions as accurately as possible.
Records may be unavailable for early crypto activities. Do your best to reconstruct transactions using wallet records, exchange logs, and bank statements. Estimate prices and costs if needed.
Conclusion
The IRS asks about cryptocurrency purchases because virtual currencies represent a significant source of unreported income and unpaid taxes. Being transparent and truthful on your tax return reduces audit risk and prevents civil/criminal penalties for tax evasion.
You must report all taxable cryptocurrency transactions, even if the 1099 forms are not furnished. Keep detailed records of your trading activity and cost basis to accurately calculate capital gains and losses. Consider amending past returns if you failed to initially report crypto transactions.