Will Your Crypto Trading Lead To An IRS Audit?

Cryptocurrency price declines this year provide the chance to lock in capital losses that potentially outweigh gains.

The IRS is aggressively working to resolve bitcoin transaction-related non-compliance. More than 10,000 tax notifications were delivered by the IRS to people who might not be in compliance in 2019. It handed out another round of tax letters to suspect taxpayers in the middle of 2020. The IRS didn’t send any letters in 2021, however this absence was more likely because to the IRS moving to remote work and dealing with stimulus-related concerns than it was due to a lack of attention.

These investigations focused largely on finding cryptocurrency traders and investors who were underreporting profits. However, because of the market downturn this year, the IRS will probably also pay attention to traders who overreport losses in an effort to reduce their tax liability.

In addition, with the Inflation Reduction Act (IRAadoption )’s in August, the IRS auditing activities are anticipated to intensify. The law made up $45 billion for “digital asset monitoring and compliance efforts,” which are expressly included in the list of enforcement actions. The agency will utilize these monies to purchase equipment and hire employees for audits and tax collection over the following ten years.

Taxpayers may be concerned about their susceptibility to IRS audits when dealing with cryptocurrencies in light of these developments. Some of the concerns may be reduced by learning the ins and outs of IRS audits and how to avoid them.

Key Concepts

Types of IRS Audits

There are four types of IRS audits.

Correspondence Audits.

The IRS most frequently does correspondence audits. These make up around 75% of the service’s tax investigations, and as of now, they are the only kind of crypto audit that the IRS has started based on the most recent data. These audits are carried out by the mail, as the name would imply. In mail inquiries, specific amounts indicated on your tax return are typically verified with further documentation.

For instance, the IRS addressed letter 6173 in 2019 to select taxpayers who were made aware of the Coinbase subpoena and asked them to submit the precise gain and loss calculations for the reported bitcoin profits and losses. Following Coinbase’s subpoena, over 10,000 taxpayers received tax letters (Letter 6173, Letter 6174 & 6174-A).

IRS Office Audits

Face-to-face meetings held in an Internal Revenue Service office are IRS Office audits. You must appear in person at a designated IRS office for these audits and provide any documents the examination officer requests.

IRS Field Audits

Compared to office and correspondence audits, field audits are more severe. To acquire thorough documentation, they are done in your house (or place of business). Business organizations frequently undergo these audits (as opposed to individuals).

Taxpayer Compliance Measurement Program (TCMP) Audits

The most thorough sort of audits are TCMP audits, which may be a frustrating experience for taxpayers. Instead of only looking at a certain section of information, the IRS now examines every aspect of a taxpayer’s return and verifies the information with sources.

How You May Be Subject To Crypto Tax Audits

The following situations may lead to an IRS audit of cryptocurrency owners.

1099 Mismatches

You may receive three tax forms from cryptocurrency exchanges: Forms 1099-K, 1099-B, and 1099-MISCs. You will get a CP2000 letter and be the target of a correspondence audit if you fail to include the amounts mentioned on these forms in your tax return.

For instance, let’s imagine you received a Form 1099-MISC stating that you made $1,000 by staking on an exchange. If you don’t mention it on your tax return, the IRS’s computer system (Automated Underreporter, or AUR) will automatically mark it as underreporting taxes by $1,000. The same rules apply if you obtain a Form 1099-B or Form 1099-K and fail to report them appropriately.

Because the IRS already has a copy of any tax forms you get through exchanges, you should absolutely disclose them to prevent a correspondence audit.

Information Gathered Through Subpoenas Issued to Exchanges

The IRS also conducts audits of cryptocurrency owners using data obtained through subpoenas. For instance, in 2018 Coinbase was compelled by a John Doe subpoena to reveal information about roughly 13,000 user accounts, including taxpayer identification number, name, birthdate, address, records of account activity, transaction logs, and all periodic statements of account or invoices (or the equivalent). The IRS subpoenaed SFOX, a Los Angeles-based exchange, in 2022 to provide information about specific crypto users. In 2021, the IRS issued a John Doe summons to San Francisco-based crypto exchange Kraken seeking information pertaining 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.”

Random Selection

You could be arbitrarily chosen for an audit in addition to 1099 reporting mistakes and subpoenas.

The IRS states that “returns are occasionally chosen based purely on a statistical algorithm. Your tax return is compared to “norms” for returns that are comparable to yours. We create these “norms” as part of the IRS’s National Research Program by auditing a statistically reliable random sample of returns.

Consider the scenario where you’ve been declaring an annual income of $50,000. However, you disclosed $2 million in cryptocurrency gains in 2021 since one of the currencies you acquired in very early had a significant rise. Even if you fully state the facts in this situation, you can still be chosen for an audit since your tax return is unusual compared to the return of the average taxpayer, who earns $50,000 year.

By selling your submerged digital assets, you may use tax loss harvesting to deduct your income by claiming a capital loss. Investors in the cryptocurrency and stock markets both adhere to this ethical standard. As long as assets are sold to an unaffiliated entity subject to untainted market circumstances, their losses are legal.

However, in really bearish situations, dishonest individuals can be persuaded to use fraudulent tax loss harvesting to generate fictitious losses. They may, for instance, sell themselves waterlogged assets at steep discounts to feign losses. Pseudo-anonymity in the cryptographic field makes this quite simple to do.

Sam, for instance, has a $1 million NFT in Wallet A. Sam also has a wallet that goes by the name of Wallet B. Sam can deceitfully declare a loss of $900,000 ($100,000 – $1,000,0000) by “selling” the NFT to Wallet B for $100,000. Under random selection, these kinds of exorbitant and illegitimate losses may be recognized.

How to Mitigate Audit Exposure

Audits involving 1099s are the simplest to avoid. By appropriately reporting amounts from 1099s on your tax return, you can fully eliminate them. Unfortunately, there is little you can do about audits that are prompted by subpoenas because you have no influence over them. Keep thorough records of your bitcoin transactions and gain & loss computations in case you are chosen for an audit through subpoenas so that you may effectively defend yourself. Finally, to lessen the possibility of arbitrary audits, you may consult with an expert tax advisor and have your tax return completed properly.

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