What Happens If You Don’t Report Cryptocurrency on Taxes?

Virtual assets, commonly known as cryptocurrency, are treated as property by the Internal Revenue Service (IRS) for tax purposes, not as currency. This classification means that transactions involving cryptocurrency are subject to capital gains and losses rules, similar to stocks or other investments. Accurately reporting all cryptocurrency activities on your tax return is important for federal tax compliance.

Understanding Cryptocurrency Tax Obligations

Tax obligations arise from specific events involving cryptocurrency, as the IRS considers it property. Selling virtual currency for traditional currency, such as US dollars, is a taxable event. The gain or loss is determined by the difference between the sale price and your cost basis, which is the amount you paid for the cryptocurrency.

Exchanging one type of cryptocurrency for another, like trading Bitcoin for Ethereum, also constitutes a taxable event. The IRS views this as a disposition of property, triggering a gain or loss calculation based on the fair market value of the cryptocurrency received. Using cryptocurrency to purchase goods or services is also a taxable event. For example, buying a coffee with Bitcoin means you are disposing of your Bitcoin, and any appreciation since you acquired it would be a taxable gain.

Capital gains and losses on cryptocurrency are categorized as either short-term or long-term. If you hold the cryptocurrency for one year or less before a taxable event, any gain or loss is considered short-term and is taxed at ordinary income rates. If you hold it for more than one year, it is a long-term capital gain or loss, which qualifies for lower tax rates. Taxpayers report these transactions on IRS Form 8949, Sales and Other Dispositions of Capital Assets, and then summarize them on Schedule D, Capital Gains and Losses.

Not all cryptocurrency activities result in a taxable event. Simply buying and holding cryptocurrency in your wallet does not trigger a tax liability until a disposition occurs. Transferring cryptocurrency between wallets or accounts that you own, such as moving Bitcoin from an exchange to a cold storage wallet, is generally not a taxable event. These actions are seen as moving your own property, not as a sale or exchange.

Penalties for Non-Compliance

Failing to report cryptocurrency transactions can lead to various penalties imposed by the IRS. One common penalty is the failure to file penalty, which applies if you do not file a required tax return by the due date, including extensions. This penalty is 5% of the unpaid taxes for each month or part of a month that a return is late, capped at 25% of your unpaid taxes.

A separate penalty, the failure to pay penalty, applies if you do not pay the taxes you owe by the due date. This penalty is 0.5% of the unpaid taxes for each month or part of a month the taxes remain unpaid, also capped at 25% of the unpaid amount. Both penalties can apply simultaneously if you fail to both file and pay on time, though the failure to file penalty may be reduced by the failure to pay penalty for the same period.

Accuracy-related penalties can also be imposed if there is an underpayment of tax due to negligence or a substantial understatement of income tax. Negligence includes any failure to make a reasonable attempt to comply with tax laws or to exercise ordinary care in preparing a tax return. The penalty for negligence or disregard of rules or regulations is 20% of the portion of the underpayment attributable to such conduct. A substantial understatement of income tax occurs if the understatement exceeds the greater of 10% of the tax required to be shown on the return or $5,000; this also carries a 20% penalty on the underpayment.

In more severe cases of intentional failure to report income or pay taxes, the IRS may impose a civil fraud penalty. This penalty is significantly higher, amounting to 75% of the portion of the underpayment attributable to fraud. Proving civil fraud requires clear and convincing evidence of willful intent to evade taxes.

For willful tax evasion, criminal penalties are possible, including fines up to $100,000 for individuals ($500,000 for corporations) and up to five years imprisonment. Criminal charges are reserved for clear evidence of deliberate efforts to conceal income or assets. Additionally, interest accrues on any unpaid taxes and penalties from the original due date of the return until the date of payment. The interest rate is determined quarterly and is based on the federal short-term rate plus three percentage points.

IRS Enforcement and Data Collection

The IRS has enhanced its capabilities to identify taxpayers who have not reported their cryptocurrency transactions. Third-party information reporting is a significant mechanism for this. Virtual asset exchanges and payment processors operating within the United States are increasingly required to issue information returns, such as Form 1099-B, Proceeds From Broker and Barter Exchange Transactions, to both taxpayers and the IRS. This form details proceeds from digital asset transactions, providing the IRS with a direct data stream to cross-reference with filed tax returns.

The IRS also employs data analytics and cross-referencing tools. They analyze various data sources, including information obtained from exchanges and publicly available blockchain data, to identify discrepancies between reported income and known cryptocurrency activities. This allows the agency to spot patterns and flag individuals whose tax filings do not align with their digital asset transactions.

John Doe summonses are another enforcement tool. These are court orders that compel cryptocurrency exchanges to provide information about specific users, even when the IRS does not know the identities of those users. The IRS has successfully used these summonses to obtain records from major exchanges, enabling them to identify taxpayers who may have failed to report income or pay taxes on their crypto holdings.

The IRS also benefits from its whistleblower program. Individuals who have information about tax evasion, including unreported cryptocurrency activities, can report this to the IRS. If the information leads to the collection of taxes, penalties, and interest, the whistleblower may be eligible for a monetary award, ranging from 15% to 30% of the collected proceeds. The IRS has a history of sending warning letters to crypto holders, such as Letters 6173, 6174, and 6174-A, urging taxpayers to come into compliance.

Correcting Past Reporting Errors

If you realize you have made errors or omitted cryptocurrency transactions on a previously filed tax return, you can correct these errors by amending your return. The primary form used for this purpose is Form 1040-X, Amended U.S. Individual Income Tax Return. This form can be obtained directly from the IRS website or through tax preparation software.

When completing Form 1040-X, identify the tax year you are amending and provide a clear explanation for the changes in Part III, Explanation of Changes. Attach any corrected or new schedules that support your amendments, such as an updated Form 8949 and Schedule D, reflecting your cryptocurrency sales, exchanges, or uses. Ensure all calculations for capital gains and losses are accurate before submitting these forms.

If amending your return results in additional tax owed, pay the underpaid amount along with any accrued interest and applicable penalties when you file Form 1040-X. The IRS charges interest on underpayments from the original due date of the return until the payment date, regardless of whether you file an amended return. Paying any additional tax promptly can help mitigate further interest accumulation and potentially reduce certain penalties.

For taxpayers with significant, willful non-compliance, the IRS’s Voluntary Disclosure Program may be an option. This program allows taxpayers to come forward and correct past tax omissions, potentially avoiding criminal prosecution, though it involves substantial civil penalties. This is a complex process and requires the guidance of a qualified tax professional. Regardless of the extent of the error, consulting with a qualified tax professional or a specialist in cryptocurrency taxation is advisable. They can help navigate the complexities of tax law, ensure accurate reporting, and determine the best course of action for your specific situation.