Avoiding the Top 10 Cryptocurrency Tax Traps

With so many rules and nuances to consider within the cryptocurrency space, it’s no surprise that many tax clients fall victim to reporting mistakes. To prevent your clients from pointing the blame finger at you, here’s what to look out for.

BY KASIA WHITE

The number of U.S. taxpayers investing in cryptocurrencies is rapidly growing. As of summer 2022, 18% of Americans had invested in different cryptocurrencies—a 125% jump from summer 2020, according to Finbold.

Even though more Americans are investing in cryptocurrencies, many tax clients are still unaware of their reporting responsibilities, and even among those who are aware, there’s often confusion on how to do so accurately as regulatory guidance has been slow to keep up with the market. This puts extra pressure on CPAs to make sure their clients accurately track, report, and pay taxes on their eligible cryptocurrency transactions.

Guinevere “Gwen” Moore, managing member of Chicago-based Moore Tax Law Group, says there’s a fundamental misunderstanding from her clients about their cryptocurrency reporting obligations, and she further warns that CPAs need to work extra hard to protect themselves in this growing environment: “If something goes wrong, we all know the client is going to point their finger straight at their CPA.”

To help clients navigate this space, here are the top 10 cryptocurrency tax traps to avoid.

Not Reporting Cryptocurrency Activity

There’s only a few scenarios where you don’t have to report cryptocurrency activity to the IRS: when the only action you engaged in was purchasing a cryptocurrency with U.S. dollars, holding it, or transferring it from one wallet to another that you possess. If your cryptocurrency activity extends beyond these scenarios, then there are IRS reporting requirements.

“I increasingly have clients with cryptocurrency reporting issues, and those typically stem from them not reporting cryptocurrency at all, or from not understanding that cryptocurrency has to be reported on a transactional basis,” Moore explains. “Whatever you do, make sure there’s a good record of the process that your client went through to determine how to report it.”

Failing to Prepare and Maintain Adequate Records

Missing data and information are one of the most difficult issues tax professionals face when handling clients’ cryptocurrency accounts.

“Clients rarely keep records or even have an idea of everything they’ve done related to it,” says Justin McCormick, senior associate in the digital assets group at Founders CPA, a Chicago-based firm. “It’s often like trying to put a puzzle together.”

Andrew Gordon, CPA, managing attorney with Gordon Law Group Ltd. in Skokie, Ill., runs into the same problem on a regular basis.

“Data collection is probably 75% of the process,” Gordon says. Most cryptocurrency platforms don’t issue tax forms, but the obligation for taxpayers to report their transactions still exists. This puts an extra burden on taxpayers to either access or create their transaction reports, provide them to their CPA, and remember everything they did. “Very often, clients will lose track of what cryptocurrency they were using and when they were using it, and that makes things more difficult,” Gordon explains. Despite these challenges, Gordon points out that the blockchain technology that cryptocurrency transactions rely on is “this record of everything that’s happened and it’s immutable. It doesn’t go away, so we can typically identify transactions to a certain address and use the information that we do have to help identify any missing information.”

Encouraging your clients to utilize software programs can help. For smaller cryptocurrency investors, creating a simple spreadsheet tracking their cryptocurrency transactions is likely enough. For others, it may be helpful to use a cryptocurrency tracking app or program, like CoinTracker.

Christopher Lazzaro, CPA, crypto tax analyst at CoinTracker says the company’s app is helpful because it “allows you to see what you paid for the crypto asset and what you sold it for. It’s a computer program, so you might need to manually address gaps on obscure tokens, but it’s generally automated and a great tool to help you maintain your records and be able to prove transactions.”

Failing to Properly Calculate Capital Gains and Losses

Much like buying and selling stocks, when your clients sell their cryptocurrencies, they should recognize a capital gain or loss based on their cost basis and selling prices.

Given the wild swings in cryptocurrency prices, Moore emphasizes that taxpayers will likely be eager to report any cryptocurrency losses to the IRS, as they can potentially offset the entirety of the tax consequences created by any realized capital gains.

In the event of lost cryptocurrency resulting from a corporate collapse, Gordon says taxpayers can’t claim a loss until that loss is certain. Meaning, a bankruptcy court adjudicates the case.

“Then the question is, is this a tax deduction? Is this a capital loss?

When can you realize it?” Gordon says. “Historically we’ve seen companies go bankrupt on other exchanges and still be able to pay out their holders.” One example is Mt. Gox, one of the largest cryptocurrency exchanges that launched in 2010 until its collapse in 2014. “A loss isn’t a loss until it’s final. With these types of losses, people often feel that they’ve lost before that’s actually the case,” Gordon stresses.

Using the Wrong Forms to Report Cryptocurrency Transactions

Information reporting requirements arise when a taxpayer starts to use cryptocurrency in exchanges, such as trading one cryptocurrency for other cryptocurrencies, or purchasing services and goods with cryptocurrency.

Where can CPAs find this information? Right now, Moore says the best resource is the IRS’ FAQ on virtual currency transactions. She notes, “If you read through those FAQs, they’ll either give you the answer to nine questions out of 10 that you’re going to have, or they’ll give you the next best place to go.” Even if you can’t reach the right answer, Moore believes you’re likely going to get to a very defensible position from an IRS adjustment standpoint and from a malpractice standpoint.

Gordon points out that the tax software that currently exists on the market meets the basic requirements for most basic cryptocurrency transactions. However, as soon as clients start to have more complex activity, for instance in decentralized finance, it’s usually a few years ahead of the software’s capability.

Gordon’s firm uses software from ZenLedger and BitcoinTaxes, but admits the accountants are left doing most of the work manually. “I would caution reliance on software because it’s in its early stages,” he says. “It’s a very new space that has a lot of nuances. Imagine designing tax software but there’s all these variables. The problem is cryptocurrency changes every year—new functions and transactions, new terms and definitions that the software has to be updated for, and often by the time it is, the tax return was due.”

Improperly Reporting Cryptocurrency Received as Earned Income

Generally, the IRS treats cryptocurrency as property, meaning that when you buy, sell, or exchange it, this counts as a taxable event and typically results in either a capital gain or loss. Taxpayers need to use Form 8949 for reporting cryptocurrency gains and losses when the cryptocurrency is treated as property. When you earn income from cryptocurrency activities, or receive cryptocurrency as compensation, it’s treated as ordinary income and should be reported on Form 1040.