Taxation and Cryptocurrency -Things You Should Know

Cryptocurrency – that is a word you hear in most financial conversations today. But, what exactly is a cryptocurrency? A digital asset, cryptocurrency has been designed as a medium of exchange to secure financial transactions, verify the transfer of assets, and control the creation of additional units using strong cryptography. Generally considered as the first cryptocurrency, Bitcoin was released in 2009 as open-source software. Since then, over four thousand alternative variants to bitcoin (also known as altcoins) have been released. Unlike central banking systems and centralized digital currency, cryptocurrency uses decentralized control working through blockchains that perform like financial transaction databases. 

Convertible virtual currencies (bitcoins and another cryptocurrency) have been held and traded by US citizens for a number of years. How does the IRS look at cryptocurrency from the taxation point of view? The IRS on the 25th of March 2014 stated that for taxation purposes, CVCs will be treated as property – thus making it subject to capital gains. In effect, it means that any exchange or sale of CVCs or their use to purchase any asset or service becomes a taxable transaction. Any gain or loss would depend on the difference between the owner/trader’s basis in the CVC used for the transaction and the fair market value of the service or asset purchased. Any exchange of one type of CVC with another, resulting in either a gain or loss, would also be treated as a taxable transaction.

This means that cryptocurrency owners/traders need to keep a track of each and every transaction involving CVCs, calculate the tax basis and report the same in their tax returns. For many, who purchased Bitcoins and held on to them or made a few sales, this will be a simple exercise. However, for the majority who purchased CVCs regularly, and used them for exchanging with other CVCs, lent them, purchased assets and services with them, received CVCs in airdrops, and invested in ICOs, this can prove to be a very difficult job. A large number of cryptocurrency owners/traders were unaware of the IRS treatment of CVCs as property and thus ended up not being compliant with their filing as per the IRS. 

Enforcement By The IRS

In July 2019, letters were sent to over ten thousand cryptocurrency owners and traders by the IRS asking them to amend their returns and pay taxes on their cryptocurrency profits. The letters 6174 and 6174-A were merely to inform the taxpayer that they ‘may have’ entered into CVC transactions and to ask them to review and determine if their filing was fully compliant. Letter 6173, however, stated that the taxpayer ‘has’ entered into transactions involving CVCs and is thus required to file amended tax returns by the due date set out in the letter. 

However, if the taxpayer has reason to believe that he/she is compliant in reporting and filing, then he/she can respond to the letter with all details of the transaction and how it was previously reported. Since this letter is signed under penalty of perjury, it is advisable for the taxpayer to seek the services of a tax attorney before doing so. Considering the numerous issues related to CVC transactions and their treatment for filing purposes, complying within the time frame given by the IRS could prove to be challenging. 

What To Do If You Have Received A Letter

In case you are the recipient of any of the three letters from the IRS, take them very seriously and get your tax attorney to help you with complying with the demands of the letter. Ignoring any of the missives can be very expensive for you in the long run. Non-compliance could and will result in stiff penalties and in some cases, criminal proceedings against the taxpayer. 

Ensure that you have reported all your CVC transactions and that their treatment has been appropriate. If there has been any transaction that has been missed out, or there exists any discrepancy in their treatment, you will need to file amended tax returns for that period as well as report the unreported transactions. This, coupled with responding to those transactions which have been flagged by the IRS but you believe to be compliant (all within 60 days) can serve to be an uphill task. 

Taxpayers should review the amended return before filing to make sure that there are no issues even with the treatment of non-CVC transactions. It may be possible that the IRS may decide to review the entire tax return and not just the amended portions.  Remember that the IRS can subpoena financial institutions, banks, and any other third party to access records related to your transactions. Thus, the taxpayer has to be extra careful in preparing their response to the letters – considering that they are unaware of the amount of information that’s already present with the IRS.