Cryptocurrency holders know more about what the Internal Revenue Service expects to see on their tax returns, thanks to new guidance from the agency.

The IRS released a ruling and a question-and-answer document Wednesday that tell virtual currency investors and their tax advisers how the agency expects them to report income from their holdings. The guidance is the first since 2014 and comes as tax auditors are increasingly focusing on examining individuals with cryptocurrency investments.

“It’s going to encourage people who weren’t in compliance to come into compliance,” said James Creech, a tax lawyer in San Francisco. People are soon going to realize “you’re going to have a lot of real paper for virtual currency,” he said.

The IRS requires taxpayers to track their crypto transactions to prove how much they bought, so they can determine how much they owe when they sell. An investor also must document transfers of coins between two accounts, known as wallets, to prove to the IRS that the transaction is tax-free.

The guidance applies long-standing tax rules, including a requirement that assets held for less than a year are taxed at higher short-term capital gains rates. Those held for longer qualify for the 23.8% preferential rates.

The IRS has struggled to enforce tax laws on digital currencies in recent years as crypto investments gained popularity and value. Until this guidance, investors and their tax advisers had relatively little input from the IRS and had to make educated guesses about how to report income and pay taxes from virtual-currency transactions. Some taxpayers didn’t report their transactions at all.

“There is a huge gap,” said Guinevere Moore, a partner at law firm Johnson Moore, said. The difference between the number of crypto account holders and the number of tax forms filed reporting income is “truly staggering,” she said.

‘Air Drop’
The guidance says that taxpayers are required to pay taxes on income when a coin splits in a transaction known as a “hard fork” and when coins are distributed through a so-called air drop.

“One unfortunate consequence of this guidance is that third parties can now create tax reporting obligations for you by simply forking a network whose coins you own, or foisting on you an unwanted air drop,” Jerry Brito, executive director of advocacy group Coin Center, said in a statement.

Taxpayers could end up owing penalties if they didn’t pay taxes on some of these transactions, even though the IRS hadn’t yet published instructions and taxpayers could have reasonably taken a different position, said Lisa Zarlenga, a partner at law firm Steptoe.

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