How the IRS is trying to nail crypto tax dodgers

For years, cryptocurrency holdings of U.S. taxpayers have existed in a sort of reporting gray zone. But now, those crypto wallets are getting a whole lot of attention from the Internal Revenue Service and President Biden, who appear determined to crack down on tax cheats.

The timing makes sense.

The president needs to raise money, relatively quickly, for his own ambitious economic agenda. And the "tax gap," which is the difference between taxes paid and taxes owed, is a big pool of cash ripe for the picking. IRS chief Charles Rettig says the country is losing about a trillion dollars every year in unpaid taxes, and he credits this growing tax gap, at least in part, to the rise of the crypto market.

The federal government is so convinced of the potential for income from back-due taxes that the White House wants to give the IRS an extra $80 billion and new powers to crack down on tax dodgers, including those parking their cash in crypto. 

"The IRS is in the business of collecting revenue," said Shehan Chandrasekera, CPA, and head of tax strategy at CoinTracker.io, a crypto tax software company. 

"Historically, if they spend $1 for any type of enforcement activity, they make $5...I think crypto enforcement activities are even higher than that," he said.

In the U.S., it is easy to be an unintentional crypto tax cheat.

For one, the IRS hasn't exactly made it easy to report this information. 

Tax year 2019 was the first time the IRS explicitly asked taxpayers whether they had dealt in crypto. A question on form Schedule 1 read, "At any time during 2019, did you receive, sell, send, exchange or otherwise acquire any financial interest in any virtual currency?"

But experts said the question was vague, and crucially, not everyone files this specific document. A Schedule 1 is typically used to report income not listed on the Form 1040, such as capital gains, alimony, or gambling winnings. 

So in 2020, the IRS upped its game by moving the virtual currency question to the 1040 itself, which is used by all individuals filing an annual income tax return. 

"[They put it] right after your name and social security number, and before you put any income numbers or deduction numbers in," explained Lewis Taub, CPA and director of tax services at Berkowitz Pollack Brant. This made the question virtually impossible to miss. 

But perhaps the bigger issue, according to Shehan, is that many filers have no clue how to calculate their crypto capital gains and losses.

If you trade through a brokerage, you typically get a Form 1099-B spelling out your transaction proceeds, streamlining the reporting process.

That doesn't happen in the crypto world, Shehan said. "Many crypto exchanges don't report any information to the IRS." 

While some crypto exchanges have begun to issue a tax form known as the 1099-K – which is traditionally given to an individual who engages in at least 200 transactions worth an aggregate $20,000 or more – in the context of crypto, this form only reports the total value of transactions. The total value does not factor in how much the person paid for the cryptocurrency in the first place, something referred to as the "cost basis," which makes it hard to calculate the taxable gain.

"A lot of people have actually over-reported their income, because they got confused," explained Shehan. 

But the biggest issue driving non-compliance is the fact that the tax rules surrounding digital currencies are still being worked out, and in a state of constant flux.

The IRS treats virtual currencies like bitcoin as property, meaning that it is taxed in a manner similar to stocks or real property. If you buy one bitcoin for $10,000 and sell it for $50,000, you face $40,000 of taxable capital gains. While this concept is relatively simple, it isn't always clear what constitutes a "taxable event."

Is buying dogecoin with your bitcoin a taxable event? Purchasing a TV with your dogecoin? Buyingan NFT with ether? 

All of the above are technically taxable events.

"The government says if I buy something with crypto, it is as if I liquidated my crypto no differently than if I sold any other property," said Taub.

Mining dogecoin for fun qualifies as self-employment income in the eyes of the government. According to cryptocurrency tax software TaxBit – which recently contracted with the IRS to aid the agency in digital currency-related audits – tax rates vary between 10-37% on mining proceeds. 

"Crypto miners have to pay taxes on the fair market value of the mined coins at the time of receipt," wrote crypto tax attorney Justin Woodward. While there are ways to get creative to minimize this tax burden, such as classifying mining as a business and deducting equipment and electricity expenses, it takes a bit of filing acrobatics to make it work.  

Earning interest on the bitcoin sitting idle in your crypto wallet also counts as income and is taxed as such. Exchanges like Coinbase have also begun to send Form 1099-MISC to taxpayers who earned $600 or more on crypto rewards or staking. 

Crypto trading volume may have fallen off a cliff in the last few weeks, but the overall market value of digital currencies is still up about 75% this year. The IRS has made it clear that it wants a piece of the action.

The agency recently ramped up efforts to subpoena centralized crypto exchanges for information about noncompliant U.S. taxpayers. 

This spring, courts authorized the IRS to issue John Doe summonses to crypto exchange operators Kraken and Circle as a way to find individuals who conducted at least $20,000 of transactions in cryptocurrency from 2016 to 2020. 

The IRS also put this same type of summons to use in 2016, when it went after Coinbase crypto transactions from 2013 to 2015.

Issuing these summons one exchange at a time is a clumsy way to capture noncompliant U.S. taxpayers, but it can be effective, according to Jon Feldhammer, a partner at law firm Baker Botts and a former IRS senior litigator.

In 2019, the IRS announced it was sending letters to more than 10,000 people who potentially failed to report crypto income. 

Rettig said in a statement that taxpayers should take the letter "very seriously by reviewing their tax filings and when appropriate, amend past returns and pay back taxes, interest and penalties."

According to Shehan, the infamous "Letter 6173" gave individuals 30 days to respond to the IRS, otherwise they risked having their tax profile examined. Letters went out again in 2020, and a fresh round of these stern warnings are expected to be sent this autumn.

Even the threat of a letter has a lot of people seeking the counsel of accountants as to whether they should get ahead of a potential audit and be proactive about amending past returns.

"A lot of people ask me on Twitter: 'Oh my god, in 2018, I had $200 worth of capital gains I didn't report. What should I do?'" recounted Shehan. "In that case, it just is not worth amending the return to pick up $200 worth of income...The high-level thing is that if you didn't do anything intentionally, you are fine."

The IRS is also getting smarter about uncovering crypto tax evaders with the help of new data analytic tools it can employ in-house. 

The agency's partnership with TaxBit is a part of this effort. Taub describes the software as being able to go through cryptocurrency wallets and analyze them to figure out what was bought and sold in crypto. In addition to enlisting the services of the vendor itself, Taub says that IRS agents are being trained up on the software as a way to identify tax dodgers.

The president's 2022 budget proposal could lead to a raft of new crypto reporting requirements for those dealing in digital coins.

The U.S. Treasury Department's new "Greenbook," released in May, calls for more comprehensive reporting requirements for crypto, so it's as hard to spend digital currencies without getting reported as it is to spend cash today.

One proposal would require businesses to report to the IRS all cryptocurrency transactions valued at more than $10,000. Another calls for crypto asset exchanges and custodians to report data on user accounts which conduct at least $600 worth of gross inflows or outflows in a given year.

Another potential major blow to crypto holders: Biden's proposal to raise the top tax rate on long-term capital gains to 43.4%, up from 23.8%. 

"Crypto gains are being taxed as any other type of gain in assets, either at long-term capital gains or ordinary rates. President Biden has proposed to eliminate the difference between the two," said David Lesperance, a Toronto-based attorney who specializes in relocating the rich. 

Lesperance told CNBC the proposal would also function retroactively and apply to any transactions which took place after April 28, 2020. 

"This translates into $19,800 in increased capital gains tax for each $100,000 in capital appreciation of crypto," he said.

Amid the rising crypto crackdown here in the U.S., Lesperance has helped clients to expatriate in order to ditch their tax burden altogether. 

"By exercising a properly executed expatriation strategy, the first $750,000 in capital appreciation is tax-free and the individual can organize themselves to pay no U.S. tax at all in the future," he said. 

But Lesperance warned that taxpayers need to move fast. "The runway to execute this strategy is very short," he said.