Crypto drops this year create the opportunity to lock in capital losses that can offset gains
The IRS is actively engaged in addressing non-compliance related to cryptocurrency transactions. In 2019, the IRS sent out more than 10,000 tax notices to potentially non-compliant taxpayers. In mid-2020, it sent out another batch of tax notices to suspicious taxpayers. No letters were sent out in 2021, though that omission likely had more to do with the IRS transitioning to remote work and addressing stimulus-related issues rather than a lack of focus.
Much of these efforts were looking for crypto traders and investors underreporting gains. However, with the market reversal this year the IRS’ focus will likely also include traders over-reporting losses in an effort to lower their tax bill.
Additionally, IRS audit efforts are expected to increase with the passage of the Inflation Reduction Act (IRA) in August. The act allocated $45 billion towards enforcement activities which specifically includes “digital asset monitoring and compliance activities”. In the next decade, the agency will invest these funds in tools and personnel focused on audits and tax collections.
In light of these developments, taxpayers may be worried about their exposure to IRS audits when dealing with cryptocurrency. Knowing the ins and outs of IRS audits and how to avoid them could alleviate some of the fears.
There are four types of IRS audits.
Correspondence audits are the most common type conducted by the IRS. These represent nearly 75% of the service’s tax investigations, and so far they are the only type of crypto audit initiated by the IRS based on current information. As the name suggests, these audits are conducted via mail. Mail requests generally ask for additional evidence to prove certain amounts reported on your tax return.
For example, in 2019, the IRS sent out letter 6173 to some taxpayers who were exposed through the Coinbase subpoena to share detailed gain & loss calculations for the cryptocurrency gains & losses reported. Coinbase’s subpoena was followed by more than 10,000 taxpayers receiving tax notices (Letter 6173, Letter 6174 & 6174-A).
IRS Office audits are face-to-face meetings conducted at an Internal Revenue Service office. Under these audits, you are required to attend a designated IRS office and present documentation requested by the examination officer.
Field audits are more serious than correspondence audits and office audits. They are conducted at your home (or office) to obtain detailed documentation. It is fairly common to see businesses being subject to these audits (as opposed to individuals).
TCMP audits are the most rigorous kind of audit and can be an unpleasant experience for taxpayers. Here, the IRS analyzes every detail of a taxpayer’s return and validates data with sources as opposed to checking a certain segment of information.
Crypto holders can trigger an IRS audit under the following circumstances.
Crypto exchanges can issue you three tax forms: Form 1099-K, Form 1099-B, and Form 1099-MISCs. If you don’t report the amounts reported on these forms on your tax return, you will receive a CP2000 letter and be subject to a correspondence audit.
For example, say you earned $1,000 in staking income on an exchange and received a Form 1099-MISC showing this amount. If you file a tax return that does not include this amount, the IRS computer system (Automated Underreporter (AUR)) automatically flags the tax return for underreporting taxes by $1,000. If you receive Form 1099-B or 1099-K and do not report them correctly, the same principles apply.
Therefore, if you receive any tax form from an exchange, the IRS already has a copy of it and you should definitely report it to avoid any correspondence audit.
The IRS also relies on information gained through subpoenas to subject crypto holders to audits. For example, in 2018, Coinbase had to disclose approximately 13,000 user accounts including taxpayer identification number, name, birth date, address, records of account activity, transaction logs, and all periodic statements of account or invoices (or the equivalent) pursuant to John Doe summons. In 2021, the IRS issued a John Doe summons to San Francisco-based crypto exchange Kraken seeking information related to the “investigation of an ascertainable group or class of persons” that the IRS has a reasonable basis to believe “may have failed to comply with internal revenue laws.”In 2022 SFOX, another exchange based in Los Angeles was subpoenaed to release information about certain crypto users.
In addition to 1099 reporting errors and subpoenas, you could also be selected for an audit randomly.
According to the IRS, “sometimes returns are selected based solely on a statistical formula. We compare your tax return against “norms” for similar returns. We develop these “norms” from audits of a statistically valid random sample of returns, as part of the National Research Program the IRS conducts.”
For example, say you have been reporting $50,000 of annual income for the past several years. However, in 2021, you reported $2 million of crypto gains because one of the coins you invested in super early generated a massive gain. In this case, it is possible that you could be selected for an audit (even when you report things accurately) because your tax return is an outlier compared to an average taxpayer making $50,000 a year.
The same principles can apply when deducting outsized losses during bear markets. Reported losses are subject to more scrutiny than gains because they lead to lower overall taxable income and higher tax refunds. As the market has reversed downward in recent months, it is possible that the IRS could be looking for tax filings that overestimate the amount of losses.
Tax loss harvesting allows you to sell your underwater digital assets and claim a capital loss that can offset your income. This is a legitimate practice followed by investors in both the crypto and stock industries. These losses are valid as long as assets are sold to an unrelated party subject in untampered market conditions.
However, during extreme bear markets, bad actors might be tempted to engage in fraudulent tax loss harvesting to create artificial losses. For example, they could create artificial losses by selling underwater assets to themselves at significant discounts. This is fairly easy to do in the crypto space due to pseudo-anonymity.
For example, Sam owns an NFT worth $1 million on Wallet A. Sam also owns another wallet called Wallet B. Sam can “sell” the NFT for $100,000 to Wallet B and fraudulently claim a $900,000 ($100,000 – $1,000,0000) loss. These types of outsized and fraudulent losses could be flagged under Random selection.
1099-related audits are the easiest to avoid. They can be completely avoided by accurately reporting amounts reported on 1099s on your tax return. Audits triggered through subpoenas are out of your control so unfortunately, there’s nothing you can do. If you get selected for an audit through subpoenas, make sure to keep detailed records of your cryptocurrency transactions and gain & loss calculations so you can successfully defend yourself. Finally, you can work with an experienced tax adviser and get your tax return professionally prepared to reduce the risk of random audits.
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Administraroot
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