If you receive a letter from the IRS about your crypto trades, contact a tax professional for guidance and submit amended or delinquent returns as soon as possible.
The IRS is now beginning its crackdown on people holding Bitcoin and other cryptocurrencies. There have been reports that some taxpayers have received a letter from the Service specifically addressing their cryptocurrency holdings. The letter is known as Letter 6174.
The letter begins by stating that the IRS has information that the recipient has or had one or more accounts containing virtual currencies. It is unclear what exactly the IRS knows. But in 2016, the agency issued a summons to popular crypto exchange Coinbase seeking the identities of their account holders. Other exchanges may have disclosed information to the IRS.
The letter also states that virtual currencies mean cryptocurrencies and non-crypto virtual currencies. I am not sure why they needed to distinguish these two. It might be because some might be confused and think both are the same. Non-crypto virtual currencies are usually in-game currencies in online role-playing games where there is a two-way conversion mechanism between real money and the game’s own currency. Two popular examples of non-crypto virtual currencies are the Second Life Linden and the Entropia Universe PED. Over a decade ago, there were reports of a few people who supposedly made a fortune selling items in-game and then cashing out their earnings into real money. The most well known example was Anshe Chung.
The letter then states that the IRS treats virtual currencies similar to non-cash property. In other words, anything other than money. This means that trading a virtual currency for anything else is a taxable event, even trading one virtual currency for another. More details can be found in IRS Notice 2014-21.
So purchasing 1 Bitcoin at $100 is not a taxable event. But if you later trade it for $1,000 worth of Ripple, you will realize a gain of $900 and will have to pay income tax on that gain. But since the IRS only accepts U.S. dollars for payment, you will have to cash out the Ripple to pay it. Suppose you cash out your entire Ripple holding for $900 to pay the tax. That is also a taxable event and you will realize a $100 loss since you obtained the Ripple when it was worth $1,000.
The above is a simple example, but it can get very confusing if you have done multiple trades on different exchanges and have multiple crypto accounts or “wallets.” While there are apps that track your trades for tax purposes they are not foolproof.
Also, Notice 2014-21 does not address what happens when the cryptocurrency splits or “forks.” Some have suggested that they be treated similar to nontaxable stock splits when one stock splits into two.
The letter advises the recipient to file amended or delinquent tax returns reporting all virtual currency transactions. But unlike regular returns, they advise the recipient to write “Letter 6174” on top of the returns and mail them to a special address. The letter also warns that not filing accurate returns can subject them to future civil and criminal enforcement activity.
So what does this mean? Given the special treatment of these tax returns, it is likely that they will be given special scrutiny. It is also likely that those with large transactions have a higher chance of being audited.
The IRS may use the returns and subsequent audits to investigate and study crypto transactions. This can lead to finding others who are willfully noncompliant. The IRS’s criminal investigation division has set up a special division for crypto transactions.
But all might not be as dire as it seems. In May, IRS Commissioner Charles Rettig sent a letter to members of Congress telling them additional guidance on cryptocurrencies will be forthcoming. The guidance will address determining cost basis and the tax consequences of forks. Unfortunately, there is no word on when these new guidelines will be released.
Also, there are some in the tax professional community who question whether the rules in Notice 2014-21 should be challenged in light of the crypto boom in the last few years. For example, there are over 1,000 cryptocurrencies and most of them are worth less than used toilet paper. Should trading Scamcoin for Fakecoin be taxable events if both are worth nothing? The possibility of litigation might incentivize the IRS to provide additional guidance as soon as possible.
For those holding cryptocurrencies, you may one day receive a Letter 6174 from the IRS. If you receive one, contact a tax professional for guidance and submit amended or delinquent returns as soon as possible. Even if you don’t get this letter, you should still file correct tax returns the old-fashioned way. The IRS’s criminal division and the Department of Justice will eventually make an example out of someone who does not comply.
Author: Steven Chung