Even the IRS Admits Some Crypto Tax Regulations Are ‘Not Ideal’

Roughly four hours into a phone call with a TurboTax representative, in which she had to sort through the company’s own internal resources in order to answer my questions, I found out I probably didn’t owe any taxes on my admittedly meager bitcoin holdings. It should have been obvious: At no point did I sell for fiat or convert into another crypto. 

In reporting this article, I was also reminded I should check my Blockchain account to see if I ever received the XLM it was airdropping because that might also result in me owing taxes on crypto (I did not). Do I need to report the $15 in bitcoin I sent to a hardware wallet I can’t access anymore? (I don’t think so?) 

U.S. taxpayers have until Wednesday to file their 2019 returns, if they haven’t already, or otherwise request an extension. I’ve been covering taxes around the crypto space for most of the past year, and have talked to more than half a dozen certified public accountants, tax lawyers and other professionals about what the IRS’s issued crypto tax guidances are actually telling us. If a reporter who’s been embedded in the space is having this much trouble, imagine how hard it might be for a complete newcomer.

This is going to remain one of the biggest barriers to mainstream adoption.

Even the IRS admits the guidance leaves questions unanswered. An IRS official said taxpayers should take advantage of both the forms that exchanges are issuing to list taxable events and the different software tools that have been built to help simplify the process. 

The official, who did not have authorization to speak publicly, acknowledged that some of the guidance published to date could be clarified and “is not ideal,” saying the agency is working to keep up with the crypto industry.

One of the major outstanding questions falls around information reporting, said Michael Meisler, a partner at Ernst and Young (EY) who specializes in taxes and is the Big Four auditor’s global blockchain tax leader. 

Taxpayers can use different methods to report how much they believe they owe, but they should be consistent when calculating gains and losses. Using weighted averages, for example, might be impermissible under existing guidance and the FAQs (which Meisler noted is not “published guidance” in the legal sense).

The IRS official agreed, telling CoinDesk that this is the next issue on its list around crypto.

“The IRS is working on guidance about how to get proper information reporting and what is the proper form of information reporting, and the IRS has recognized that that guidance is lacking as far as what the exchanges should report on,” the official said. “We’re working on that as part of our guidance plan and that is really probably the top most guidance priority for the IRS, in, in the realm of virtual currency at this time.”

Other questions

Another unanswered question around crypto taxes revolves around staking, Chandrasekara said. He pointed to Ethereum’s pending upgrade to Eth 2.0, which will see the second-largest cryptocurrency’s consensus mechanism switch from proof-of-work (where computers maintain the network by running complex calculations and issuing blocks with crypto in them as a reward for miners) to proof-of-stake (where computers maintain the network by locking in large amount of wealth from validators that earn annualized interest as new blocks are issued).

“There’s a lot of people making passive income through staking,” he said. 

It gets weirder with decentralized finance. While centralized exchanges are publishing 1099 forms and sending both the IRS and taxpayers information about their transactions, decentralized platforms might not be.

“DeFi platforms aren’t issuing tax forms,” Lodha said. 

Margin trading is another issue where unsophisticated users are ending up with leveraged positions, since crypto derivatives settled in crypto essentially mean the taxpayer is receiving property at the end of the transaction. 

“There’s pretty clear guidance on non-crypto futures, like if you’re trading regulated commodity futures, that are [U.S. Commodity Futures Trading Commission] regulated, there’s like a ton of legislation around how that works,” he said. 

Crypto futures fall into a fuzzier category, particularly as unsophisticated traders (like some Robinhood users) might end up with highly leveraged positions without understanding the tax implications, he said. 

The way IRS guidance on airdrops and hard forks is currently worded may be unclear, the official added.

At present, the biggest issue the IRS has is a resource one, given how quickly the industry changes and the other issues facing the agency today, including the response to COVID-19.

“[The] industry changes so quickly that to try and keep up with the industry and make the guidance relevant [is challenging]. At the same time the IRS has been facing other legislations with regard to the Taxpayer First Act and then some of the legislation with respect to COVID,” the official said. “The biggest challenge is just kind of resource, and facing the other legislative priorities that have been coming out.”

Still, the IRS has published multiple pieces of guidance and its FAQs, which shed some light on what taxpayers might owe and how they should calculate those costs. 

Filing your taxes

What the IRS has made clear is taxpayers need to file if they made (or lost) any money as a result of exchanging their crypto for fiat or another cryptocurrency; if they gained any crypto as a result of airdrops or hard forks; or if they gained funds as a result of staking or mining. 

The IRS added a mandatory question to the U.S. tax return last year, asking if the individual held or transacted with crypto during the year. 

“That question proves intent, so if you lie to that and then the IRS finds out through [a] 1099 that exchanges issue or through scanning the blockchain … then all of a sudden it can turn criminal,” said Austin Woodward at crypto tax startup TaxBit. “It is important to take that question seriously and answer it honestly.”

The IRS is cracking down on crypto taxes this year in a way the agency hasn’t in past years, said Chandan Lodha of CoinTracker, another crypto tax service. 

He pointed to the 1040 form, last year’s updated guidance and the 10,000 warning letters the IRS sent out to taxpayers last year. IRS job postings also seem to indicate that the agency is “doubling down on hiring consultants” to track transactions and de-anonymize transactions. 

If taxpayers don’t have the necessary information to fully file their taxes, they should file for an extension, said CoinTracker’s Shehan Chandrasekara (Lodha said doing so is “super trivial” with no downside). 

He noted that the extension only allows taxpayers to file their forms later, but any payments they owe are still due on July 15. 

Just by filing an extension, taxpayers might avoid having to pay a penalty for being late on their paperwork, he said. Still, they might owe some penalties for paying late (which is better than not filing at all and potentially being audited).

“My recommendation is if somebody doesn’t have all the information to figure out their tax liability, just be more conservative,” he said. If a filer says they made more on crypto than they actually did, they’ll get whatever excess they paid back. 

Remaining compliant

The IRS takes enforcement more seriously than comparable agencies in most other countries, Woodward said, similar to the Australian Tax Office. 

The agency mailed some 10,000 letters to taxpayers in 2019, asking them to verify their crypto transactions and offering hints at how to calculate their fair holdings’ fair market value. A second set of letters warned taxpayers that they may have incorrectly reported their holdings, and detailing what the agency believed to be the correct amount owed.

“I think right now [the IRS’s taxation treatment] falls in line pretty closely with that of equities so it’s nothing new. It’s been around for you know decades now,” Woodward said. “It’s just cumbersome in the crypto space as opposed to the equity space because there’s so much more transaction volume.”

The IRS is definitely taking the space seriously though, he said, a sentiment Lodha echoed. 

There’s “significant evidence” that the IRS cares, including through its recent postings seeking expertise around crypto transactions, Lodha said.

The IRS official CoinDesk spoke to recommended using the different software tools that have been released. 

“Taxpayers should at least use the information that their exchanges provide and reflect that on their returns, and there are tools out there that they can use that interact with these exchanges that [conduct] the process now kind of seamless in the realm of someone who’s engaging in cryptocurrency transactions,” they said.

It’s important to be careful when using different software products as well, Meisler warned. Different software solutions running the same data might calculate different gains/losses due to how they interpret guidance. This could happen if one solution calculates fees different from another, for example. 

The taxpayer would still be responsible for accurately reporting their holdings to the agency, he said.

“If the guidance is lacking the taxpayer should use their best efforts and then take consistent positions from their reporting,” the IRS official said.