Cryptocurrency is more accessible than ever before. Banks are continuing to both implement procedures for and, in some cases, develop their own cryptocurrencies. Paypal allows users in the U.S. to buy, sell and hold select cryptocurrencies directly through PayPal and it will enable cryptocurrency as a funding source for purchases in 2021. Volatility in the price of cryptocurrencies continues, and is likely to continue, but it is becoming a more recognized investment and method of payment. As more taxpayers integrate cryptocurrency into their finances, they should consider tax implications. Here are some things to remember about current or future cryptocurrency transactions and investment.
The IRS Focus on Cryptocurrency
The IRS will remain actively engaged in enforcement efforts through taxpayer education, audits, and criminal investigations. The IRS previously used a John Doe Summons (allowing the IRS to summons information on a class of taxpayers where the names are unknown) to identify 13,000 account holders at Coinbase. In 2021, the IRS will likely expand its use of the John Doe Summons power to further identify non-compliant taxpayers. In August 2019, more than 10,000 taxpayers received letters indicating that they may have failed to report income at all, or properly, and pay the required taxes. One variant of the letter sent by the IRS requested a response under penalties of perjury. More letters are likely to follow in 2021. The 2019 individual tax return (Form 1040) required taxpayers to affirmatively state if they engaged in cryptocurrency transactions on Schedule 1. The 2020 Form 1040 moves the question to the front page of the tax return – indicating its increased importance.
If you have cryptocurrency, or buy cryptocurrency in 2021, make sure it is properly reported because the IRS is watching.
Tax Reporting for Cryptocurrency
The IRS FAQs state that all income, gain, or loss involving virtual currency must be reported regardless of the amount or if you received a form W-2 or 1099. Because cryptocurrency is treated as property (like stocks or real estate), taxpayers pay taxes if they realize a gain but may be able to claim losses when they realize them. As property, taxpayers must know when they bought the cryptocurrency, how much they paid, and what they received for it. This can sometimes be difficult if the purchase was outside of an established exchange or inherited without clear documentation. Also, because cryptocurrency is treated as property, every exchange can trigger gain or loss. This makes small every-day purchases cumbersome to report. However, as services like Paypal allow for broader use of purchases with cryptocurrency, this tracking for tax reporting may become easier.
The IRS updated Form 14457, Voluntary Disclosure Practice Preclearance Request and Application, so that it now includes unreported income from virtual currency. This option is designed for taxpayers who face potential criminal exposure for their non-reporting. Criminal exposure is usually present where facts appear to indicate a willful failure to report cryptocurrency amounts and transactions. If the facts indicate an inadvertent or non-willful failure to report then another option is filing a qualified amended return that can avoid some, but not all, tax penalties. Taxpayers should be careful because if they misjudge their facts, the amended return can still result in fraud penalties and criminal prosecution. The IRS has, in the past, instituted specific voluntary disclosure programs to encourage compliance for certain types of non-reporting (e.g. foreign bank account reporting). However, the IRS hasn’t indicated any plan to do so with cryptocurrency despite claiming that there is widespread non-compliance.
Cryptocurrency is referred, by some, as the future of banking. Regardless, its users are definitely growing and will continue to grow in 2021. Therefore, more taxpayers will need to consider the tax implications of their cryptocurrency holdings and transactions to ensure compliance.