The Crypto Taxman is Coming. Should You Be Worried?

April 18 is the deadline for filing taxes in the U.S., and, just like last year, the first question on the IRS return asks if the taxpayer owns any cryptocurrency. This shows the Treasury Department now regards crypto taxation as an important source of income, and that it's more determined than ever to collect it.

This recent attention from the IRS has sparked fear and loathing among many in the crypto community—fear that they may owe a lot of money, and loathing because the tax agency's own guidelines can be confusing and incomplete, especially when it comes to newer parts of crypto like DeFi or NFTs.

Crypto owners do have cause for concern but, according to tax experts, those who make a good faith effort to pay their taxes will probably emerge OK. Here's an overview of how the IRS is likely to treat crypto owners' tax returns.

Is the IRS up to the job?

Even as the IRS move to process this year's tax returns, it still has a backlog or nearly 20 million filings from last year. This situation is tied in part to staffing woes that have the left agency able to answer barely 10% of the phone calls it receives. Given these constraints, is the IRS really in position to police the complicated crypto sphere?

The answer is yes. According to Matthew Van Buskirk, a former regulator and co-founder of compliance startup Hummingbird, the IRS may be short-staffed but it has also acquired the tools to track and audit even complex crypto transactions.

"They have invested heavily in sophisticated tech to keep up with the evolving crypto space," says Van Buskirk, who notes the IRS's criminal investigation unit is especially renowned, but that it's also well equipped to carry out run-of-the-mill audits.

In practice, this means the agency is using both blockchain analytics tools from the likes of Chainalysis, as well as its own software, to investigate transactions across a wide variety of wallets and exchanges. In some cases, this will involve the agency asking exchanges or tax software providers for additional information about specific individuals.

But while the IRS has the know-how to audit even complicated crypto returns, the process can be resource intensive.

"I'd be surprised if they’d be doing it at scale because it's very hard," says Gil Hildebrand, CEO of Gilded, a company that provides accounting services to merchants that store or accept crypto.

The IRS's task is especially difficult when it comes to DeFi, where crypto traders have made enormous amounts of money, but which revolves around semi-autonomous protocols rather than centralized exchanges. According to Van Buskirk, the decentralized nature of these protocols can make it hard for tax collectors since there may not be a traditional company they can subpoena for customer records. In those cases, he says the IRS may go after the protocol's creators, though that may become impractical over time as DeFi infrastructure expands.

Meanwhile, users of decentralized crypto platforms will often have to figure out their obligations for themselves—a task that is by no means easy.

What happens if you're audited?

While the IRS has made clear they expect people to pay tax on their crypto earnings, for many it won't be clear how much they owe. Even the smallest crypto transaction can give rise to a capital gain obligation, while the cost basis for any profit may not be obvious—for example, if someone buys Bitcoin 10 times over five years and then sells half of it, how do you calculate the profit?

In the case of stocks, brokerages are obliged to furnish annual 1099 forms that break down things like capital gains and dividend profits. Crypto exchanges, for now, have no similar obligation, though platforms like Coinbase are beginning to provide customers with rudimentary estimates on what they might owe. Those estimates, however, don't necessarily take into account crypto activity involving decentralized wallets or protocols.

Those carrying out frequent trades or interacting with DeFi will likely want to turn to the growing number of companies, including TaxBit or Koinly, that offer specialized crypto tax software—or ask their accountant to do the same.

But even relying on these specialty services doesn't guarantee a crypto owner will calculate what the IRS believes is owed. This is in part because the law is unclear when it comes to certain activities such as staking, or holding NFTs, which can conceivably be taxed as long-term capital gains or at a higher rate that applies to collectibles. Even the tax experts aren't sure of the answer.

While crypto owners may face some truly nightmarish scenarios, the good news is that most people won't be audited and that the IRS won't come down hard on people who make a good faith effort to pay what they owe.

"The broader tax audit strategy is to not go after the average person, but more egregious people. It's more of deterrence mechanism," says Van Buskirk.

Hildebrand expressed a similar sentiment, noting, "If you’re making a reasonable effort to get this stuff done, and using one of dozens tools, you’re giving detailed info—that’s a pretty good effort."

The upshot is that most people who report crypto earnings are unlikely to be unaudited, and, if they are, will face adjustments but not penalties from the IRS over honest mistakes.

That's not the case for those who fail to report their crypto earnings at all, especially if they've made a lot of money. Tax experts agree that the IRS may have sympathy for people who bungle their taxes, but none for those who seek to avoid them altogether.

Hildebrand notes that some crypto owners have stuck to a belief that they shouldn't have to pay tax—a belief that's not just wrong, but fails to appreciate they'll still come out ahead even after paying taxes.

"Some people are so resistant to taxes that when they have capital gains, they forget they actually made money," he added.

(If you're looking for an overview of how to reduce crypto taxes, please see "Five Ways to Minimize Your Crypto Tax Hit" by CPA Lewis Taub).