26 November 2020

crypto currencies and taxes

The Internal Revenue Services has started sending out letters, known as CP2000 notices, to cryptocurrency holders notifying them that they have been potentially underreporting their cryptocurrency holdings on their tax returns.

CP2000 notice
Source: H&R Block

CP2000 Notices, which are one of the most common IRS crypto warning letters, are often sent when the agency believes that there is a discrepancy between the individual’s income that it has on file, and the information reported via tax returns.

How Does the IRS Identify Potential Crypto Holders?

In previous articles, we have written about how cryptocurrency exchanges are rapidly resembling traditional banks in their effort to obtain required licenses to operate in each state. The result is that they have adopted common practices in the financial sector, such as Anti-Money Laundering (AML) and Know Your Customer (KYC), where they collect and disclose information on their customer bases.

In aligning with state and federal regulations, cryptocurrency exchanges provide required IRS forms and federal and state reporting to their users who have met minimum transaction thresholds. In particular, the IRS receives 1099-K forms from the crypto exchanges and subsequently places the responsibility on the customer to keep an accurate record of all sales and exchanges of capital assets.

Why Is This a Unique Event?

Earlier this year, the IRS drew the attention of taxpayers as it unveiled its intent to generate income from individuals that are actively concealing their cryptocurrency assets and trading activity.

In fact, the IRS showed their intent by prominently and directly asking the following at the top of the first page of the 1040 income tax form:

“At any time during 2019, did you receive, sell, send, exchange or otherwise acquire any financial interest in any virtual currency?”

1040 crypto question
Source: Forbes

For taxpayers who falsely answer “no” to the question, they may be greeted with the IRS crypto warning letter around Thanksgiving this year. With information from the 1099-Ks that they receive from the exchanges, the IRS already knows how much cryptocurrency an individual has traded in the last year.

How Do You Respond If You Receive A CP2000 Notice?

The first step is to verify the authenticity of the letter. Unfortunately, it has become common practice for scammers to falsify IRS notices. There are a few ways to verify if an IRS notice is legitimate:

1. Check to ensure that it arrived in a government envelope with an official IRS seal
2. ensure that the notice includes your truncated tax ID number, as well as the tax year(s) in question in the upper-right hand corner
3. IRS Contact Information Is Prominently shown at the top of the letter

The next step will be to audit how you calculated proceeds from cryptocurrency transactions in the tax filing. Cryptocurrency is classified as property by the IRS, where the taxpayer is liable for identifying any gains or losses when you buy, sell, or transact with cryptocurrency. An advisable solution would be to use tax software that specializes in calculating tax liabilities for cryptocurrencies, such as TaxBit.

Virtual Currency Transactions that can affect taxes
Source: United States Government Accountability Office

Lastly, you should cross-reference the “proposed amount” on the form with the earnings or losses that you reported in your filing. It’s important to remember that the amount proposed by the IRS is not a final bill and you have an opportunity to appeal their calculations by disclosing supporting documentation for the total that you proposed.

In Summary

There was a long period of time that cryptocurrency investors benefitted from gray areas and uncertainties to avoid disclosing their holdings and subsequent earnings from cryptocurrencies.

In a similar move to the IRS’ efforts to curb tax evasion from offshore accounts, the IRS has their sights set on cryptocurrency and individuals who are not disclosing their assets and trading activity. As Benjamin Franklin said, “There are only two things certain in life: death and taxes.” It’s critical that you address the CP2000 Notice if you receive it in the mail while taking steps to ensure that proper disclosure is provided on filings moving forward.

For the latest news on cryptocurrency and trading, check out our new “Getting Started in Bitcoin and Crypto” course and learn more about becoming a member of the Dchained community today.

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