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Got crypto? Here’s how to avoid an audit from the IRS

Key Points
  • Different taxes may apply, depending on how you received or disposed of your cryptocurrency.
  • In extreme cases, failure to report your transactions can result in fines up to $250,000 and prison.
  • There are more than 1,500 known virtual currencies.
Alexander Demianchuk | TASS | Getty Images

Whether you were paid in ethereum or you sold some of your bitcoin in 2017, one key question will determine your responsibility to the IRS: What's your cost basis?

As Tax Day — April 17 — approaches, holders of cryptocurrency ought to take a moment and review their holdings as well as all of their transactions throughout 2017.

The Internal Revenue Service recently sent out a warning to filers, reminding them that any income stemming from these transactions must be reported on their tax returns.

In the worst case, failure to properly report your virtual currency transactions may lead to fines of up to $250,000 and prison.

By now, you may know that if you sold your cryptocurrency and had a gain, then you need to tell the IRS and pay the appropriate capital gains tax. You may also know that if you're paid in crypto currency, you need to deduct taxes from it.

Bitcoin investor? What do to when the tax man comes knocking
Bitcoin investor? What do to when the tax man comes knocking

Here's where things get complicated: In order to calculate the taxes you owe, you need your cost basis — that is, the original value of the asset for tax purposes — and this information can be hard to find.

"There isn't any official reporting mechanism in place," said Sarah-Jane Morin, who is of counsel at Morgan Lewis. For instance, Coinbase, an exchange for cryptocurrency, is doing some reporting, providing a Form 1099-K to some but not all customers.

"The way the IRS is looking at this: they feel like people should comply and use their best efforts to figure out cost basis," Morin said.

That means it's up to you to hunt down your cost basis. Here's how you can get started.

Scouring exchanges

For example, if you needed to hunt down the cost basis of some long-held stocks and your brokerage firm didn't have that information, you could dig up historical prices and dividend payments to get a sense of your cost basis.

The process is less straightforward with cryptocurrency, which any one investor can trade on multiple plaforms: There are at least 190 exchanges for virtual currency.

"The exchange price on Coinbase might be different from Kraken or Poloniex," said Jake Benson, founder of Libra, a software company that provides tax reporting for cryptocurrency.

The key issue with a lot of these transactions is that it'll be better to try to do the best you can.
Sarah-Jane Morin
of counsel, Morgan Lewis

For instance, when you have activity in multiple venues, he said.

"When you have some holdings in wallets off exchange and you transact with friends, that's where complexity occurs," Benson said.

Gifts of cryptocurrency are also reportable: In that case, you inherit the cost basis of the person who gave it to you.

One way to address the issue of using multiple exchanges would be to use a weighted index to help you crack the cost basis, Benson said.

Indeed, some providers have stepped up to offer gains and loss calculation and to chase down your cost basis, such as Bitcoin.Tax and LibraTax, a service Benson's firm provides.

Paid in virtual currency

Chesnot | Getty Images

Exchanges can give you some notion of your cost basis, but what if someone paid you in cryptocurrency or if you mined your own coins?

Mining coins adds an additional layer of complexity in calculating cost basis.

"Are you a passive investor who was mining virtual currency? Were you doing it as an employee? Did someone pay you to do it?" asked Morin.

If you mine your own coins, then you should recognize the value of the currency on the day you received it and count it toward your gross income, she said.

If a third-party is paying you to mine coins, then you may be receiving payment as an independent contractor and you would be responsible for self-employment taxes.

Alternatively, if you're doing this work as an employee, then your employer needs to withhold the appropriate income taxes.

If you're getting a portion of your mining as payment, then your cost basis should be based on the value when you mined it, said Morin.

No transaction too small

How to choose the right crypto exchange for you
How to choose the right crypto exchange for you

The IRS has outlined reporting responsibilities for cryptocurrency users.

Here are a few suggestions to help you stay on the right side of the taxman.

Think beyond sales: If you bought a cup of coffee from a merchant that accepts virtual currency, you'll need to report it.

"You can get cryptocurrency as a gift or for payment," said Benson. "It's a cost basis event, and you have to manually record the fair market value you when you received it."

Track everything: Maintain records of your transactions and translate them to U.S. dollars. At least you'll be ready if the IRS comes knocking.

"When you're buying and selling coins, track the date and the amount paid," said Morin.

Don't assume you can swap cryptocurrency free of taxes: Traders have made tax-free "like-kind" exchanges of virtual currency in the past. Don't assume that the IRS will continue to allow this.

"Like-kind exchanges must be of real property, like houses and buildings – it can't be coins," said Morin. If you have swapped one virtual currency for another, you still need to report the "like-kind" exchange to the IRS and track the basis.

"The key issue with a lot of these transactions is that it'll be better to try to do the best you can," said Morin. "Do the best you can rather than avoiding it altogether."

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