Avoiding Audits: Common Mistakes When Filing Crypto Taxes
And you thought regular taxes were hard...
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Filing crypto taxes can be quite tedious and frustrating, as the process requires data from every exchange account and wallet you have ever used for a transaction. This is exacerbated by the fact that crypto is so new that the tax rules are not very clear to the average investor. As a result, mistakes in crypto tax filings are commonplace.
Even the IRS acknowledges this and sent out letters to some 10,000 crypto investors reminding them of their tax obligations as well as urging tax payers to revise their tax filings to ensure they are error-free.
In this article we will take a look at ways to avoid the most common mistakes that investors tend to make when filing their crypto taxes.
1. Report capital gains on crypto → crypto transactions
It is a common misconception that you only have to pay tax when you actually sell a cryptocurrency for fiat. However, the IRS clarified back in 2014 that cryptocurrencies are treated as property – and not actual fiat currencies. One consequence of this classification is that any exchange of such property is also taxed.
Let’s say you bought 5 ETH for 1000 USD and later traded it for 1 BTC when the price of a Bitcoin was 5000 USD. Here you would be making a capital gain of: 5000 – 1000 = 4000 USD, which must be reported.
2. Report Income received in cryptocurrency
Another pitfall that was also highlighted in the recent IRS letters has to do with actual income from cryptocurrencies i.e. payment in return for a service. Any crypto that has NOT been generated through trading is considered either ordinary income or additional income and must be reported in your tax return.
Some examples of income from cryptocurrencies are:
- Crypto payments for a job or service
- Income generated from Mining or Staking
- Masternode income
- Income from crypto lending (DeFi payments)
If you receive such income you should note its market value at the time you received it and report that as additional/ordinary income in your annual return. Any eventual sale or trade of that crypto will result in capital gains which are reported separately.
3. Declare crypto gained from Forks, Airdrops etc
Hard forks are great opportunities to gain tokens out of thin air. Moreover, there are instances where crypto companies distribute free tokens to the masses. Some of these schemes require users to execute simple tasks like tweeting, sharing on facebook, or signing up.
Common “free token schemes” include Hard forks, Airdrops and Bounties.
The tax treatment of such cryptocurrencies is quite vague, and the IRS has not issued any guidelines on the matter. The American Bar Association wrote a letter to the IRS for clarification as well as a proposal on how these should be treated – but there has been no response yet.
For now, most crypto accountants as well as the ABA recommend the following for declaring such assets:
- Any airdrops/bounties received in return for an action, like retweeting or registering, should be perceived as Income in return for service and be treated as regular income.
- Airdrops received purely as a gift or promotion should be given a cost-basis of 0 and only declared as a capital gain when you dispose of the assets.
- Hard forks should take on a cost-basis of zero as there is no market for the forked currency at the time of the fork.
- Bounties/rewards are treated in the same way as interest from lending your cryptocurrencies, i.e, regular income.
4. Include full trading history (Previous Years + All Wallets)
This is another obvious pitfall. When filing a tax report for 2019, for instance, investors might fail to include data from previous years of trading.
This would make their reports inaccurate since the cost basis also depends on the transactions from previous years. For instance, if a trader had bought Ether in 2017 and traded it with other tokens through the years, the transaction data from that initial buy is crucial in calculating the cost-basis.
It is also equally important to include data from every exchange and wallet that you have used to trade. If you transferred funds from one wallet to another and later moved those funds back to the original wallet – you will need the intermediary wallet so you can clarify to the IRS that the transaction was simply a transfer to your own account and not a trade or disposal.
5. Report Everything, Even If You Didn’t Make Profits
Crypto losses are clearly unfavorable outcomes, but that doesn’t mean you are not required to report them. All previous years of trading data have to be included in order to calculate your capital gains. If you don’t report data for a year, there will be discrepancies in your tax reporting for subsequent years.
Not only that, it is generally in your best interest to report capital losses. The IRS allows you to deduct up to $3000 from your income if you make a capital loss and even allows you to carry the remaining loss to the next year.
6. Use the correct cost-basis method to calculate your gains
Cryptocurrencies are taxed under the capital gains guidelines, which are calculated by subtracting the cost basis (buying price) from the selling price. The IRS allows two accounting methods to calculate the cost basis:
- FIFO (First In First Out) – the coin you bought first is also sold first. This is the recommended and most-used method.
- LIFO (Last In First Out) – you sell the coin that you bought last first
The two methods are basically opposites and will result in very different capital gains. It is worth noting that you are not allowed to swap between them, once you start using one of these methods you will need to stick to it. If you really want to switch you have to ask the IRS for written permission prior to filing your return.
Cryptocurrencies are slowly but surely gaining the attention of tax agencies around the world. So, if you feel your tax reporting has been lacking, it is best to file an amended tax return as soon as possible to avoid penalties down the line.
Be sure to seek solid advice from a tax professional if you had significant investments in cryptocurrencies, or just need some personal advice.
Robin Singh is the founder of Koinly.io – a cryptocurrency tax solution that makes it easy for investors to generate income and capital gains reports for USA, Europe & Australia.
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