Tax Blog

Can Cryptocurrency Cause Tax Debt?

Can Cryptocurrency Cause Tax Debt?

Have you invested in the phenomenon that is cryptocurrency? Or are you still afraid to take the risk of venturing into the unknown?

Though there are benefits to having virtual assets, many people aren’t aware of the tax implications that go along with them.

Whether you already own some form of cryptocurrency or you’re still on the fence about it, you should be aware that the IRS sees all virtual money as property – and they want to collect their share.

In this article, we’ll tell you more about what virtual money is, how it is used, and the impact it could have on your tax returns. Let’s get started.

What is Cryptocurrency?

The idea of digital money has been toyed with since the early 1980s. However, the very first form of decentralized cryptocurrency, Bitcoin, was only introduced to the world in 2009.

Unlike traditional, physical currency that generally comes in the form of printed bills and coins, cryptocurrency is not governed by a centralized authority. Instead, it is operated through peer-to-peer networks called blockchains.

In order to send or receive digital money, you need a public as well as a private encryption key. This ensures that both the sender and the receiver verify transactions through digital signatures. A ledger keeps track of all transactions that have taken place and makes them public. However, everyone who has taken part in these transactions remains totally anonymous.

Since the release of Bitcoin, thousands of alternative cryptocurrencies have been created. Some of these include Litecoin, Ethereum, and Tether. According to CoinMarketCap, there are nearly 5,000 digital currencies.

What Can Cryptocurrency Be Used For?

Though the various types of cryptocurrencies have different functions, most of them are generally used to pay for goods or services.

In addition to that, some investors buy and sell virtual money to turn a profit. This has resulted in many people gaining extreme wealth, which is why cryptocurrency has caught the government’s attention.

Is Cryptocurrency Taxable?

At first, Bitcoin wasn’t very popular, so the government didn’t pay too much attention to it. But, in 2014, all of that changed.

As more and more people started to capitalize on the cryptocurrency craze, the IRS realized that it was missing out on some serious income. As a result, it published a notice to explain how virtual currency would be regulated from that point forward. The basic message of this notice was that the IRS would view cryptocurrency as property. This meant that all tax rules that are relevant to property transactions would also apply to cryptocurrency transactions.

The notice was not originally very forthcoming and left many taxpayers confused as to how they should declare their virtual income. As a result, less than 1% of electronically filed tax returns in 2016 declared cryptocurrency income.

In October 2019, the IRS released more descriptive guidelines that addresses the following points:

  • The tax liabilities that are created by cryptocurrency forks (upgrades to blockchain networks)
  • How cryptocurrency received as income should be valued
  • How taxable gains should be calculated when cryptocurrencies are sold

According to this guidance, new cryptocurrencies should be viewed as ordinary income that’s equivalent to “the fair market value of the new cryptocurrency when it is received.”

Simply put, this means that you will be subject to paying taxes whenever any new cryptocurrencies are recorded on a blockchain and you have control over them.

Unfortunately, this means that the IRS can still levy tax reporting obligations on you for forked or airdropped assets. For example, someone can maliciously airdrop a token to you without your realizing it. Depending on the fluctuation of the token’s value, you could be liable to pay income tax on a virtual asset that had more worth when you received it than when you sell it.

Consequences of Ignoring Cryptocurrency Taxes

The IRS is actively examining taxpayers’ involvement with cryptocurrencies. In fact, during the infamous Coinbase saga in 2017, the court ruled in favor of the IRS, giving it permission to collect data on all the customers of the digital wallet company. This allowed it to collect back taxes from the tens of thousands of users who did not declare their virtual assets.

But it doesn’t stop there. On July 26, 2019, the IRS announced that it was sending out letters to more than 10,000 taxpayers who were involved in cryptocurrency transactions and potentially failed to report their virtual income properly or fulfill their tax obligations that resulted from these transactions.

This sprouted from a Virtual Currency Compliance campaign that was launched by the IRS during July 2018, in an attempt to address tax non-compliance related to the use of cryptocurrencies.

The lesson here? Failing to report all income on your tax returns, including virtual assets such as cryptocurrencies, is a federal crime. This means that if you were one of the thousands of taxpayers that received either letter 6173, letter 6174, or letter 6174-A, you could be liable for penalties or even jail time if you don’t review your tax filings accordingly.

Conclusion

Just because crypto trading is anonymous doesn’t mean your activities are hidden from the IRS. In fact, the IRS has made it its mission to collect the government’s share on your virtual income. If you have received any income whatsoever by using cryptocurrencies, Uncle Sam will eventually find out about it.

Therefore, you should decide whether the complex tax implications of trading in virtual currency are really worth the effort.

If you’re not sure how to declare the income you received from the use of virtual money, you should consult a tax professional to ensure that you don’t accidentally break the law. After all, you wouldn’t want to be slapped with a hefty fine just because of a few digits on a computer.