Over the past month, the IRS—the tax-collecting agency of the United States—has sent out more than 10,000 warning and action letters to suspected cryptocurrency traders and holders who may have misreported digital assets on their tax returns. These IRS crypto letters come in three variations 6173, 6174, and 6174-A, and they specifically address cryptocurrency holdings.
The problem here is that the IRS doesn’t have all of the necessary information. In fact, not only does it not have all the information but the information that it does have on the cryptocurrency holders that it is sending letters to is extremely misleading. This information, which was supplied to the IRS by cryptocurrency exchanges like Coinbase, is causing the agency to blindly and oftentimes inaccurately come after cryptocurrency traders.
How is Crypto Like Bitcoin Taxed in the U.S.?
In many countries around the world — the U.S. included — cryptocurrencies like Bitcoin are treated as property from a tax perspective, rather than as a currency. Just like other forms of property — stocks, bonds, real-estate — you incur capital gains and capital losses that need to be reported on your tax return whenever you sell, trade or otherwise dispose of your cryptocurrency.
Pretty straightforward: If you make a lot of money investing in Bitcoin, you have a capital gain and a tax liability that needs to be reported. If you lose a lot of money, you have a capital loss, which will actually save you money on your tax bill — though it still needs to be reported.
It doesn’t come as a huge surprise that many cryptocurrency users have not been paying taxes on their cryptocurrency activity. It makes a lot of sense why the IRS has started carrying out these enforcement campaigns. However, the agency is using information that is extremely misleading, and it is leading to problems. This misleading information starts with Form 1099-K.
Crypto exchanges like Coinbase, Gemini, Bittrex, and others issue 1099-K’s to users who meet certain thresholds of transaction volume on their platforms. The IRS states on its website that the 1099-K is an information return used to report third-party network transactions to improve voluntary tax compliance.
In other words, the 1099-K is used to report your gross transactions on a third-party network — in this case, a cryptocurrency exchange. All of your transactions, buys, sells, transfers, etc. are summed up and reported on a 1099-K. If you meet certain thresholds — gross payments that exceed $20,000 and more than 200 such transactions — you and the IRS are both sent a copy of this 1099-K from the cryptocurrency exchange. The IRS is using these documents to monitor who is and isn’t paying taxes correctly.
The Problem With 1099-K’s
1099-K’s are reporting gross transaction amounts and are being sent to the government. Yet, these reported numbers are completely irrelevant when it comes to reporting crypto on your taxes, as you are only actually taxed on your capital gains and losses.
Again as an example, say you purchased $10,000 worth of Bitcoin in April and then sold it two months later for $9,500. You have a $500 capital loss that would be deducted from your taxable income. However, reported on 1099-K, nothing is said of your net loss; the form only tells the government that you have $19,500 of gross cryptocurrency transactions.
Ultimately, 1099-K is not a form that should be used for tax reporting purposes, yet the IRS is relying on it for enforcement. Many people often mistake the 1099-K that they receive from cryptocurrency exchanges with the typical 1099-B that they might receive from their stockbroker or other investment platforms outside of crypto. The 1099-B is the correct form that reports all necessary information required to calculate and accurately report capital gains and losses — including cost basis and fair market value of your investments. It’s very easy to determine your total capital gain and loss with this form, contrary to 1099-K.
The fact that the IRS is relying on 1099-K to issue action letters is problematic. Unfortunately, cryptocurrency exchanges do not have the ability to give you an accurate Form 1099-B.
Why crypto exchanges can’t provide tax reports
Because cryptocurrency users are constantly transferring crypto into and out of their exchanges, the exchange itself has no way of knowing how, when, where or at what cost (cost basis) you originally acquired your cryptocurrencies. It only sees that they appear in your wallet on their platform.
The second you transfer crypto into or out of an exchange, that exchange loses the ability to give you an accurate report detailing the cost basis and fair market value of your cryptocurrencies, both of which are mandatory components for tax reporting. In other words, cryptocurrency exchanges do not have the ability to provide you with the necessary information to calculate your capital gains and losses. This also means that they also don’t have the ability to provide you with a 1099-B.
Coinbase itself explains to its users in its FAQs that their generated tax reports won’t be accurate if any of the following scenarios took place:
- You bought or sold digital assets on another exchange.
- You sent or received digital assets from a non-Coinbase wallet.
- You sent or received digital assets from another exchange, including Coinbase Pro.
- You stored digital assets on an external storage device.
- You participated in an initial coin offering.
- You previously used a method other than ”first in, first out“ to determine your gains/losses on digital asset investments
These scenarios affect millions of users.
The information that the IRS is receiving from cryptocurrency exchanges does not reflect your capital gains and losses whatsoever. This is problematic because these capital gains and losses are what you actually pay crypto and bitcoin taxes on, not gross transaction amounts.
So, if you received a warning letter from the IRS, don’t panic. As long as you have been properly filing your cryptocurrency gains and losses on your taxes, you should be fine. The absurdly high numbers that you are seeing on these letters are oftentimes irrelevant. Nonetheless, it is a good idea to consult a cryptocurrency tax professional who is familiar with digital assets for further help and clarification — especially if it’s an action letter.
David Kemmerer is the co-founder and CEO of CryptoTrader.Tax, a tax reporting platform for cryptocurrency investors.
Featured image: Wtok-TV