The IRS reckons that tax dodgers cost the government more than $400 billion annually. In addition to tax-savvy corporations and billionaires, the agency believes the multi-trillion-dollar crypto industry is behind the widening “tax gap” in recent years.
If you’ve received a letter from the IRS reminding you to report your crypto taxes, you’re probably aware that the agency is cracking down on crypto tax evasion. But even if you haven’t received a letter, that doesn’t mean you’re in the clear.
In this article, we’ll look at whether you’re at risk of an audit and what to expect if you receive the dreaded audit notice in the mail.
Are You at Risk for a Crypto Tax Audit?
The IRS has made significant progress since releasing its first crypto tax guidance in 2014. After winning a legal battle to subpoena exchanges for customer records, the agency began sending thousands of notices to taxpayers suspected of underpaying taxes.
In 2021, the IRS expanded these efforts in “Operation Hidden Treasure.” After equipping and training agents with forensic crypto tools, the agency began combing through the treasure trove of subpoenaed data to identify potential tax evasion.
While the average audit risk is just 0.6% to 1% per year, crypto holders have an estimated audit rate of 2% to 5% per year. Generally, the risk increases with the number of crypto transactions you have and the size of your crypto holdings.
If you received a crypto notice from the IRS, you’re at the highest risk of a crypto tax audit. These notices include Letter 6174, 6174-A, and 6173. But, of course, you may still experience an audit even if you did not receive one of these letters.
What Happens During a Crypto Audit?
The IRS will always notify you of an audit by mail – never by telephone or in person.
Depending on the circumstances, you may be able to reply by mail or meet an auditor in person to review your records.
The most common request during an audit is to provide any wallet and blockchain addresses you own, along with any crypto exchanges or other custodial accounts.
For each transaction in these accounts, you may need to provide:
- The date and time you acquired the asset.
- The cost basis and fair market value at the time you acquired it.
- The date and time you disposed of the asset.
- The sale price or fair market value when you dispose of it.
- An explanation of the cost basis method you used.
In addition, the IRS may request other records related to these transactions, such as email confirmations for crypto exchange transactions.
Consider speaking to a qualified tax attorney if you realize you made a mistake or omission. Any admission of guilt to an IRS agent or even an accountant can be used against you in court if the agency decides to prosecute you for tax evasion.
Once the audit is over, you will receive a letter that explains the findings and the amount you may owe in taxes. If you disagree with the findings, you have 30 days to appeal the decision – just because the IRS proposed changes doesn’t mean they’re right!
And in rare cases, if the IRS finds that you evaded taxes or committed fraud, they may refer your case to the Department of Justice for criminal proceedings.
How Long Will a Crypto Tax Audit Take?
The length of time an audit varies depending on your situation.
If you only trade on a single crypto exchange, an audit might only take a week and a single correspondence by mail. But if you have complex transactions, like staking and yield farming, you might be in for a months-long process.
Audits may also take longer if the IRS decides to examine past tax returns. While a standard audit only covers three years, it can extend to six years if the agency finds “substantial errors” in the returns. And if there’s fraud, there is no time limit.
How to Prepare for a Crypto Tax Audit
The best way to prepare for an audit is to organize your transactions.
You should already have a list of transactions on Form 8949, but you may need to re-reconcile these with your wallets and exchanges. This task may involve matching up each disposal with an acquisition to prove the cost basis you reported is correct.
While it’s possible to do this in a spreadsheet, crypto tax software can help automate and streamline the process. For example, ZenLedger automatically connects to your wallets and exchanges, imports transactions, and computes capital gains and losses. You can also generate a new Form 8949 to compare it to the one you filed with the IRS.
ZenLedger makes it easy to import transactions from exchanges or upload transactions via CSV from a wallet. Source: ZenLedger
ZenLedger also handles more complex crypto transactions like mining, staking, airdrops, and other yield farming. That way, you don’t have to worry about characterizing different types of transactions and computing the proper tax obligations.
And finally, unlike many other crypto tax solutions, ZenLedger provides a Grand Unified Accounting report with all your transactions in one place. This thorough reporting can be invaluable if you need to provide your accountant or an auditor with a robust record of transactions.
Tips for Avoiding a Crypto Tax Audit
It’s impossible to eliminate the possibility of an IRS audit – but you can significantly reduce the likelihood of one by taking specific steps.
The most impactful step you can take is accurately reporting your capital gains, losses, and income. Since spreadsheets can be error-prone, consider automating the process by using ZenLedger or other crypto tax software. Several of these solutions even integrate with TurboTax and other tax prep software to eliminate mistakes.
The IRS may receive information from third parties, such as Form 1099s, that doesn’t match the information you provide on a tax return. When that happens, the IRS will send CP2000 notices to address the discrepancy. If you receive these notices or crypto-specific letters, you must reply within the specified time limit (typically 30 days).
Consider speaking with an accountant or other tax professional if you have a complex tax situation. They can help you decide how conservative to be with transactions with multiple potential treatments and could discover tax deductions to minimize your overall tax liability.
Explore more on how to avoid crypto tax audit.
The Bottom Line
The IRS believes half of crypto gains may go unreported, which explains why it has aggressively increased its enforcement efforts. With its recent hiring spree and new technology investments, these actions will likely continue to accelerate.
If you received a crypto warning letter – or worse, an audit notice- you may wonder what’s next. The good news is that an audit is nothing to worry about if you properly report your crypto transactions. But, sometimes, you may need to amend your tax return or make other adjustments based on the audit findings.
If you want to reduce the likelihood of an audit or prepare for an audit, ZenLedger can help aggregate all your crypto transactions in one place, compute your capital gains, losses, and income, and generate the forms you need to file each year.
The above is for general info purposes only and should not be interpreted as professional advice. Please seek independent legal, financial, tax, or other advice specific to your particular situation.
