Cryptocurrency such as bitcoin, Luna, UST and Tether (USDT) have been in the news lately. So what is crypto? Crypto is not legal money. It is property, similar to gold. Like gold, its use can result in taxable income.

The IRS is concerned that you and millions of Americans are using crypto without paying tax on the earnings. To clarify that it expects you and other taxpayers to report crypto earnings, the IRS added the following question about cryptocurrency to the top of Form 1040:

At any time during 2021, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?

You must answer this question under penalty of perjury, even if you have never heard of bitcoin and don’t know what cryptocurrency is. You can’t leave the field blank.

Unfortunately, this is something of a trick question. It is so broadly worded; you’d think any transaction involving digital currency requires a “yes” answer. But that is not the case.

IRS guidance makes clear that it is interested only in virtual currency transactions that result in taxable income (or loss) that must be reported on a taxpayer’s return.

Thus, for example, if you simply purchased bitcoin during the year and held on to it, you should answer “no” to the crypto question. The same goes if you received crypto as a gift, or transferred crypto from one wallet to another.

You should answer “yes” to the crypto question if you purchased or sold goods or services with crypto, received new crypto through mining or staking activities, exchanged crypto for dollars or other crypto, or got new crypto from a hard fork. All these activities result in taxable income (or loss).

What should you do if you answered the crypto question wrong?

If you answered the crypto question “yes” when you should have answered “no,” you don’t have to do anything. There is no need to amend your tax return.

On the other hand, if you answered “no” when it should have been “yes” and you did not report your taxable virtual currency transactions, you need to file an amended or superseding return. If you fail to do so, you may get a letter from the IRS advising you to file an amended return and pay any taxes due.

The IRS began sending out such letters in 2019. We are seeing Increased monetary surveillance and ultimately tax notices and fines being sent to crypto users due to Operation Hidden Treasure. In November 2021, 9 million CP12 notices were sent out.

Operation Hidden Treasure

Thanks to Operation Hidden Treasure, the IRS likely knows you and others have cryptocurrency, due to their efforts in data aggregation and analysis of all pseudonymous blockchains via third party contractors, and hires directly to the IRS Administration, from that talent pool at those contractors. Because of this hiring initiative the IRS is now comprised of agents who are trained in cryptocurrency and virtual currency tracking, and who are focused on taxpayers who omit cryptocurrency income from their tax returns. Operation Hidden Treasure is a working relationship between the civil office of fraud enforcement and the criminal investigation unit to stop tax evasion from cryptocurrency owners. Damon Rowe, the Director of the Office of Fraud at the IRS, announced Operation Hidden Treasure at a meeting at the Federal Bar Association that took place on March 5th, 2021.

This effort along with comments made on June 25th 2021 by James Lee (Chief of IRS Criminal Investigation) and Darren Guillot (IRS Deputy Commissioner) at the New York Tax Controversy Forum Corridor Consulting attended show the seriousness the government and the IRS are taking against individuals not reporting their cryptocurrency.

“Crypto space we see you, we have dozens of cases in the pipeline due to our J5 working relationship, many cases will be public in the next few weeks. It’ll be a busy summer for the crypto space”-James Lee

“Across the country we have…virtual currency experts who know how to trace on the blockchain, value it, seize it and sell it.” “Do not believe we do not know you have virtual currency.” – Darren Guillot

Corridor Consulting has been assisting new clients in filing these amended returns, and can offer our expertise in correcting these returns.

If you’ve omitted multiple years of substantial cryptocurrency income from your returns you need to amend, we recommend you seek legal counsel along with our services, as the IRS has viewed amendments as criminal admissions on the part of the taxpayer even if they were not aware of the tax implications at prior filing deadlines. If you are currently being charged criminally and need an accountant, please have your attorney contact us.

Even if you have aggregated your cryptocurrency reports and reported them each year, you are likely going to run into issues if those reports do not follow proper cost accounting logic, such as Last in First Out (LIFO) or First in First Out (FIFO). The IRS is likely to challenge taxpayers who utilize Specific Identification also known as Highest In First Out (HIFO) due to the nature of tracking specific coins and lots being comingled in exchanges and wallets.

For example if you switch from LIFO one year, to FIFO or HIFO the next the gain or loss will be over or understated based on that year’s market condition, and purchases made. We’ve had clients discover they reported under FIFO the prior year, and moved to LIFO on a new tax software, only to massively understate their gains for the year. Typically we see this in long-term holders of Bitcoin who have had massive appreciation in their assets from their initial purchase in 2008-2016. If you are changing accounting methods to lower your taxable gain that is NOT allowed, you must stick to one method. Otherwise the IRS in an audit will likely call into question your cost accounting method. So what do you do, if you’ve been using inconsistent methods? We recommend amending tax returns to be consistent and pay the taxes owed. Paying the taxes through an amendment of tax year(s) is a much better option than being audited.

If you need any help regarding these issues, please reach out to Corridor Consulting, we would love to assist you in any issues you may have. If you’d like to schedule a consultation you can do so here.

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This article is not professional tax or legal advice for your specific circumstances. Consult with your professional adviser to better understand how these items may impact you, or how they’ve changed