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Have you recently found yourself staring at a letter from the IRS, reminding you about those crypto taxes you may have overlooked? 

In Fact 3.8 out of every 1,000 returns, or 0.38%, were audited by the IRS in 2022, That was down from 4.1 out of every 1,000 returns filed, or 0.41%, the prior year. But don’t sweat it - you’re definitely not alone. In fact, getting that heads-up from the IRS might be a blessing for the future, Giving you ample time to face a potential crypto tax audit. 

Yep, The IRS has been pretty vocal about it lately - they're tightening the rules on crypto, and audits are becoming more common. So, if you've received a notice or an audit request, don't worry. We’ve got your back with all the info you need to prep for that IRS crypto tax audit.

Is crypto taxable in the USA?

The IRS doesn't view cryptocurrency as regular money. Instead, they see it as something you own, like stocks or property you rent out. This means when you sell your crypto and make money, you might have to pay one of two kinds of taxes: Capital Gains Tax or Income Tax.

Capital Gains Tax is what you pay when you make a profit by selling/Disposing the asset.

Income Tax is what you pay on the money you earn, like when you get cryptocurrency from: 

• Staking
• Liquidity mining 
• Airdrops

To learn more about how cryptocurrency gets taxed in the US, you can check out our USA Crypto Tax Guide. 

Will the IRS know if I don't report my crypto?

Even if you haven't received any official audit notice yet, you might still be feeling anxious about it or you might not be worrying about it at all - but maybe you should be.

The IRS is stepping up its game when it comes to auditing people who deal with cryptocurrency. You might have noticed this when they asked a specific question on the 2020 Form 1040 Individual Tax Return, “At any time during 2021, did you receive, sell, exchange or otherwise dispose of any financial interest in any virtual currency?”. Now, they're taking it further. In the draft for the 2022 tax return, they've added a whole section dedicated to digital assets, which everyone in the US needs to fill out. Plus, CNBC & Reuters reported that “the IRS got a whopping $80 billion boost in their budget to hire more agents. It's all part of their plan to keep a closer eye on crypto investors”.

But it's not just your tax return that could put you on the IRS's radar. They're also pressuring US-based crypto exchanges such as Binace, ByBit, Gemini, KuCoin to share customer information (KYC) through John Doe Summons as part of Operation Hidden Treasure, adding to their ability to track crypto transactions.

On top of all that, the IRS recently talked about the "tax gap" in 2023 - basically, the difference between what they collect and what they should be collecting. And it's a whopping $688 billion! And guess what? Crypto is part of the reason for that gap, according to the IRS. So, with all these signs pointing in the same direction, it's likely that crypto tax audits will be on the rise in 2023 and 2024.

Did you know about Operation Hidden Treasure and John Doe Summons?

Ever heard of Operation Hidden Treasure? An initiative launched in March 2021 by the IRS. It's a move to catch folks who aren't paying their fair share of taxes on cryptocurrency.

You see, one big draw of crypto is that it can be anonymous. That means the IRS has a hard time figuring out who's doing what with their crypto. So, they've taken legal action to get around this.

They've petitioned the federal courts for something called a John Doe summons. This forces crypto exchanges to hand over info about their users to the IRS. With this info, the IRS can spot folks who aren't playing by the tax rules when it comes to crypto.

The IRS has already won these summons against big exchanges like Coinbase, Kraken, and Poloniex. And when they get this info, they're looking for anyone who's made transactions of $20,000 or more in a year. For example, over 10,000 Coinbase users got letters if they didn't report all their crypto income, and many ended up facing audits.

Now, lots of exchanges are trying to play nice to avoid getting hit with these summons. They're following regular financial rules and sending out forms like the 1099 to users and the IRS, showing who's been making big transactions.

In short, if the IRS wants to know about your crypto, they've got ways to find out. They'll look at your past tax returns, your financial info, and any data they can get from exchanges to make sure you're paying what you owe.

Wondering if the IRS might be eyeing your crypto investments for an audit?

Here's how to spot the signs…

First off, keep an eye out for a letter from the IRS. Since 2019, they've been sending out three different types: Letter 6174, 6174-A, and 6173.

Letter 6174 is like a gentle reminder, letting you know that crypto is taxable and explaining how to report it properly. Think of it as a friendly nudge in the right direction.

Then there's Letter 6174-A. This one's a bit more serious. It warns that the IRS might take enforcement action if you don't handle your crypto taxes correctly. If you get this letter, it's probably time to consult with an accountant to sort things out.

Last but not least, there's Letter 6173. This is the big one. It's sent to folks the IRS suspects of dodging their crypto taxes. If you receive this letter, you've got a deadline to respond or face perjury charges. Better act quickly and either explain it through a letter detailing how you've been following the rules or file an amended tax return.

Even if you haven't gotten a letter and you haven't used an exchange that's caught the IRS's attention, you could still end up facing an audit. The IRS might get curious about your crypto investments if your financial records don't match up with your tax return. If they see any discrepancies, you can bet they'll want to dig deeper.

So, what happens during an IRS crypto audit? That's the next question we'll tackle.

What to Expect During an IRS Crypto Audit

When the IRS audits your crypto activity, the questions they ask can vary. However, there are some common things they'll want you to share:

• All your wallet IDs and blockchain addresses.
• Details of any digital currency exchange accounts and P2P facilitator accounts you have.

For each transaction, you'll need to provide:

• The date and time you got each crypto asset.
• How much each crypto asset cost and its Fair Market Value (FMV) when you got it.
• The date and time you sold or got rid of each crypto asset.
• How much you sold each crypto asset for or its FMV at the time you got rid of it.
• An explanation of the accounting methods you used to calculate the cost basis for each crypto transaction (FIFO, LIFO, or HIFO).

The IRS might also ask for more details, like records of any communication you had with other counterparties about your crypto transactions, such as emails confirming those transactions. 

How long does a tax audit typically take?

The length of a tax audit depends on how complex your crypto transactions are. If your crypto dealings are straightforward, like using a couple of exchanges for basic trades, the audit won't take much time.

But if you've had thousands of transactions in a financial year, including more complicated stuff like liquidity mining or yield farming, the audit will definitely take longer.

During the audit, the examiner will go through all the documents they asked for and might consult with crypto experts for more insight. If they find any discrepancies in your tax reports, they'll likely have more questions.

Once the audit wraps up, you'll get a letter detailing the findings and any taxes you might owe. You've got 30 days to say if you disagree with their decision. However, if they suspect tax evasion or fraud, they might involve the Department of Justice for legal action instead.

How Long Can the IRS Look Back on Your Financial Records?

The IRS typically looks at the last three years of your financial records during a regular audit. If they think there are big mistakes, they might go back six years. But if they suspect fraud or you haven't filed a tax return, they can look back as far as they want.

For crypto investors, this means it's crucial to keep really good records of all your transactions. That way, if the IRS asks for info, you've got it ready to go.

One easy way to stay organized is by using a crypto tax app like Kryptos.

How to be prepared for an IRS Crypto Audit

Preparing for an IRS crypto audit can be done in two ways, and one is much simpler than the other. Let's go over both:

1. DIY Crypto Tax Records: This involves creating a detailed spreadsheet of all your crypto transactions for at least the past three financial years. For each transaction, you'll need to record the date, time, Fair Market Value (FMV), cost basis, and more. It's quite a task, so we suggest considering the second option.

2. Use a Cryptocurrency Tax Software: With a crypto tax App/Software, everything is done for you. All you have to do is connect all the wallets, exchanges, or blockchains you use with the app. You can do this either by using an API or importing your transaction history via a CSV file. When you use the API, most of the time, it will fetch your complete transaction history from the wallet or exchange. If you opt for CSV file import, you can easily download these files from your wallet or exchange and upload them to the crypto tax app. The app then crunches the numbers for you, calculating your cost basis, gains, losses, income, and expenses. It generates a Comprehensive Tax Report that includes all the details the IRS might need to see for each individual transaction. You can download multiple reports to cover all the financial years the IRS might be interested in auditing.

Smart Steps to Avoid a Crypto Tax Audit

While there's no guaranteed way to avoid a crypto tax audit, there are steps you can take to lower the risk.

Firstly, make sure you accurately report all your crypto gains, losses, and income. The IRS has clear rules about reporting crypto transactions. You need to include your gains and losses in Form 8949 and Schedule D, and your income in Schedule 1, along with your Form 1040 Tax Return.

This can get complicated, especially if you're actively trading crypto. But using a crypto tax app like Kryptos can simplify the process. Kryptos handles all the calculations for you and even generates pre-filled tax forms, saving you time and hassle.

Additionally, if you've had any significant changes in your income, be sure to provide documentation explaining these changes along with your tax return. The more information you provide, the less likely the IRS will have further questions.

When filing your tax return, be diligent in checking for errors. Whether you're doing the calculations manually or using a tax app, it's essential to review everything to avoid underpaying or overpaying taxes on your crypto.

If you're mining crypto as a business, it's tempting to maximize business deductions. While deductions are legitimate, be cautious not to overdo it. Excessively large deductions can raise red flags with the IRS.

Wondering if you should talk to an accountant? 

Yes, definitely, especially if you're dealing with a crypto tax audit.

Crypto tax rules in the US can be complex, especially for newer concepts like DeFi transactions. While a crypto tax app can help calculate your gains, losses, and income based on current IRS guidelines, it's not a substitute for professional tax advice. If you've been notified of an IRS crypto audit or suspect you might face one, seeking advice from a tax professional is crucial to ensure compliance.

Be sure to choose an accountant who has experience dealing with cryptocurrency.

Looking for an Easy Way to Handle Your Crypto Taxes?

To be ready for a crypto tax audit, it's important to track, calculate, and pay your crypto taxes accurately. Kryptos offers a simple solution for this.

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With Kryptos, you can easily connect with all your crypto wallets, exchanges, or blockchains using API integration or CSV file import. This allows you to import your complete transaction history, and Kryptos will automatically track all your crypto transactions, including capital gains, losses, income, and expenses. You can easily view all this information in your dashboard and tax summary.

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When tax time comes, you can effortlessly download the specific tax report you need. For US users, this includes Form 8949 and Schedule D for capital gains and losses, and Schedule 1 for income. Additionally, if you're using popular tax apps like TurboTax or TaxAct, Kryptos provides reports tailored for them.

In case you face a crypto tax audit from the IRS, you can rely on Kryptos to generate a Complete Tax Report with all the necessary details about your crypto transactions across all your trading platforms.

FAQs

1. Why Should I Be Concerned About IRS Auditing My Crypto Taxes?

The IRS has significantly ramped up its efforts to enforce tax compliance in the cryptocurrency space, signaling increased scrutiny through various measures like the addition of virtual currency questions on tax forms and Operation Hidden Treasure. With audits becoming more common and the IRS's access to information from exchanges, it's essential to ensure your crypto tax filings are accurate.

2. What is Operation Hidden Treasure and John Doe Summons, and How Does It affect Me?

Operation Hidden Treasure is an IRS initiative aimed at identifying individuals who underreport or fail to report cryptocurrency-related income. Through John Doe Summons, the IRS compels exchanges to disclose user information, enabling them to identify potential tax evaders. This initiative enhances the IRS's ability to track crypto transactions and enforce tax laws, increasing the likelihood of audits for non-compliant individuals.

3. How Can I Determine if the IRS Might Be Targeting My Crypto Investments for an Audit?

The IRS typically sends out three types of letters (6174, 6174-A, and 6173) to inform taxpayers about their crypto tax obligations. These letters vary in severity, with Letter 6173 indicating potential non-compliance and the possibility of facing perjury charges. Additionally, discrepancies between your financial records and tax filings could trigger IRS scrutiny, even without receiving a letter.

4. What Should I Expect During an IRS Crypto Audit?

During an IRS crypto audit, you'll need to provide detailed information about your crypto transactions, including wallet IDs, exchange accounts, transaction dates, costs, and sale prices. The audit process can vary in duration depending on the complexity of your transactions, with more extensive trading histories requiring additional time for examination and potential consultation with crypto experts.

5. How Can I Be Prepared for an IRS Crypto Audit?

Preparation for an IRS crypto audit is crucial and can be simplified through two methods: manual record-keeping or using cryptocurrency tax software like Kryptos. While manually tracking transactions can be labor-intensive, crypto tax software automates the process by aggregating transaction data from various sources and generating comprehensive tax reports. This ensures that you have all the necessary documentation to navigate an audit seamlessly.

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All content on Kryptos serves general informational purposes only. It's not intended to replace any professional advice from licensed accountants, attorneys, or certified financial and tax professionals. The information is completed to the best of our knowledge and we at Kryptos do not claim either correctness or accuracy of the same. Before taking any tax position / stance, you should always consider seeking independent legal, financial, taxation or other advice from the professionals. Kryptos is not liable for any loss caused from the use of, or by placing reliance on, the information on this website. Kryptos disclaims any responsibility for the accuracy or adequacy of any positions taken by you in your tax returns. Thank you for being part of our community, and we're excited to continue guiding you on your crypto journey!