The IRS is increasing scrutiny on cryptocurrency investments and the tax treatment for these assets.
For example, the crypto transaction question has been made longer on the next 1040 federal tax return and U.S. authorities recently obtained special authority to question crypto exchanges about certain transactions and investors.
Earlier this year, the Biden administration issued an executive order requiring various agencies to produce reports this fall relating to cryptocurrency regulation.
There's also a building sentiment for potential changes in tax laws to address concerns about cryptocurrencies. “In 2014, the IRS formally recognized that virtual currencies such as bitcoin ... are to be treated as property more akin to a commodity than a security for taxation purposes,” said Mark Connors, head of research at 3iQ in New York. “Since then, the IRS continues to enforce tax laws on U.S. citizens who engage in the buying and selling crypto assets.”
Recently, for instance, a U.S. District Court judge in California authorized the IRS to seek information from a Los Angeles-based cryptocurrency prime dealer about U.S. taxpayers who conducted at least the equivalent of $20,000 in transactions in crypto between 2016 and 2021. The goal: hunting for tax cheats. The IRS has also pledged to investigate crypto-involved tax fraud as part of its new enforcement initiative after a bump in funding from the Inflation Reduction Act.
The IRS isn’t the only federal agency tightening enforcement on cyrpto. Early in 2022, BlockFi Lending LLC agreed to pay a $50 million federal penalty as well as $50 million in fines to 32 states after being charged by the Securities and Exchange Commission with failing to register the offers and sales of its retail crypto lending product.
For federal tax purposes, the IRS says virtual currency is treated as property, with general tax principles applicable to property applying also to transactions using virtual currency. The IRS does not treat virtual currency as currency that could generate foreign currency gain or loss for U.S. federal tax purposes.
“It’s clear that the U.S. and other jurisdictions recognize the advantages of digital assets as well as the need to regulate both protect the consumer and limit malfeasance,” Connors said. “As more U.S. government bodies explore benefits and risks with crypto assets, including the immutability of blockchain activities, we expect that enforcement will continue to increase.”
Especially as crypto technology gets involved. Advancement of blockchain analysis tools and their integrations within crypto exchanges and federal agencies is a major recent development in crypto tax enforcement, said Connor Loewen, cryptocurrency analyst at 3iQ in Toronto. “Several private businesses offer these tools and services,” Loewen said. “These businesses work in concert with enforcement agencies and engage in white labelling blockchain-based addresses and produce risk profiles for these addresses. These firms have also worked with federal prosecutors as expert witnesses.”
Though crypto asset transactions can be pseudonymous, venues which allow the trading of crypto assets with fiat currency regularly engage with government bodies, including the IRS, and utilize KYC/AML monitoring services.
“If a pseudonymous wallet was to send crypto to an exchange account wishing to convert it back into fiat currency, the pseudonymous wallet now has an audit trail tying it with a KYC/AML-enabled account,” Connors said. “Since crypto exchanges in the U.S. are regulated entities that enforce KYC/AML, they could disclose that clients’ information to the IRS for possible prosecution if there are grounds to believe that they didn’t file these gains or losses on their tax returns.”