They can seem complicated. They will most definitely seem boring. Above everything else though, filing your cryptocurrency related taxes properly and accurately is a vital part of the trading process. While it’s rare and your intent would likely have to be malicious for failures to be so severe, failure to correctly file your taxes can result in unbelievable fines in the realm of $250,000 or more and, in some cases, even jail time. There are numerous ways someone can mess up their crypto tax filings to varying levels of severity. With that in mind, let’s take a look at some of the most common mistakes cryptocurrency traders make when filing their taxes.
Incorrectly Reporting Capital Gains
Let’s get the most obvious one out of the way first. If you trade cryptocurrency, you’re going to have to pay a capital gains tax. There are some misconceptions floating around in the metaphorical ether that traders will only be obliged to pay capital gains taxes on their coins when converting them to cold, hard cash. This is false. Because of the way the IRS treats cryptocurrency, any transfer of cryptocurrency is treated as a transfer of property and therefore taxed as such.
Not Reporting Losses
Every year, a number of crypto traders will only report their profits when filing. It’s not hard to understand why they do it. After all, how many people think that losses are something important enough to file. Surely losses wouldn’t affect the amount of tax they’d be paying? Why would it, since the tax is being assessed specifically on the profits?
The truth is, if you aren’t reporting your cryptocurrency losses, you’re just leaving money on the table. Your losses in the crypto markets, when properly filed with your taxes, can reduce your taxable income overall, shaving money off your tax bill. It can seem counterintuitive at first, but there are no situations where you’ll want to avoid reporting your crypto losses.
Keeping Sloppy Records
As with all things in finances, keeping proper records is key. Sloppy records can mean that you inadvertently over or underpay on your capital gains taxes, which will cause you greats pains once tax season rears its ugly head.
To avoid unwanted hassle, make sure to keep a record of all your crypto-related transactions as soon as each is confirmed. Details to include consist of the date the coin was acquired, it’s basic dollar value, the date it was sold, and the profits you gained. You’ll be able to use this information in your crypto tax software of choice to calculate your cost basis and report your gains.
Not Including Previous Activity
It might seem like common sense to only include your recent crypto activity when filing annual taxes. After all, why would previous years be relevant, especially since you’ve already reported them when they were new?
Unfortunately, including all of your trading history is a must when filing cryptocurrency taxes. This has to do with a financial concept known as the cost basis. The cost basis is an asset’s original value, which is based on when it was purchased by its current owner. Since cryptocurrencies can vary in value in quite a significant way over relatively minor periods of time, the only way to accurately establish the cost basis of a coin is to include your past trading activity. Without this, your reports will be invalid.
Not Including All Exchanges
Over the course of their bitcoin trading, traders will likely make use of a number of trading platforms. While some of these platforms, especially major ones such as Coinbase, will send 1099-K forms to simplify matters, traders will still need to report gains from all exchanges they have used. Without including data from every single exchange you’ve ever used, a tax profile simply cannot be created accurately.
Misclassifying Your Crypto
Cryptocurrencies can be received in a number of ways, and many of them will have to be specially classified accordingly. While trading is going to be most people’s main source of crypto coins, failing to note when a coin is received by a different means can cause headaches that could have been prevented.
Forks and Airdrops
Typically when a trader has forgotten to classify a coin, its either from a fork or an airdrop. For the purposes of the IRS, and therefore this article, soft forks, hard forks, splits, and airdrops are all functionally the same thing, and so we’ll just refer to them as forks. When a fork occurs, two new currencies are created. The original or ‘classic’ version, still operating off the set of rules it had when created in the first place, and the ‘new’ version, which has had its rules changed in reaction to some event. Usually, this has to do with the recouping of losses stemming from theft. Traders who haven’t been part of a fork before might not grasp exactly what has happened, or they may simply forget to properly document the change to their portfolio.
The problems that this causes will begin to crop up quickly. If you use an automated crypto tax software to create the tax reports you use, the program will need to be shown how exactly the new coins you have were acquired. If the trader has failed to properly classify these new coins they’ll seem to have appeared from nothing, which in turn means that the software won’t understand how you are trading these mystical coins in the future, messing up otherwise simple reports later on.
If you’ve already found yourself facing this particular set of circumstances, you needn’t fret too much. By adding your forked coins as an incoming transaction within your compatible tax program of choice, you should be able to remedy the situation. Still, it costs you time, both in the fixing and in diagnosing the problem. If you can avoid small complications like this, you should.
While it’s much less common than many of the other pitfalls mentioned in this article, some traders can find themselves receiving cryptocurrency as payment for goods and services in addition to that which they obtain through trading. Like those coming from forks, coins that find their way into your account as income are treated differently in tax systems than those received through common trading. For tax purposes, coins gained through actual cryptocurrency mining are also classified as income. For all income received as cryptocurrency, the date and time of receival is required, no different than when you mark down trades.
Inconsistent Cost-Basis Methodology
There are two ways to account for the cost basis, the most common being First In First Out, which has the coin bought first also being sold first. This is the method most will recommend, and indeed it is practically the default mode of calculation. Some, however, calculate the cost basis of their coins using the Last In First Out method, in which the coin you bought last will be the first coin sold. While either of these methods is valid for use in filing your crypto taxes, it’s worth noting that they can lead to very different capital gains totals.
The choice of which to use is ultimately up to each trader, but once you’ve started using one method, you’re stuck. The IRS doesn’t allow you to change the method you use between filings, or at least not easily. If you’ve wound up using a method that doesn’t work as well for you, you’ll have to physically send an inquiry to the IRS asking for permission to switch to the other method, and there isn’t any guarantee they’ll answer your request within a reasonable timeframe.
Not Considering Using Professionals
It’s not required. It’s not always going to be necessary. But it would be wise not to rule out bringing in professional accountants, especially those specializing in dealing with crypto trading.
It’s not impossible to successfully do all the data gathering and note-keeping yourself, but it can be a tedious process, and one with many points of failure at that. For traders who just don’t have the time or the drive to calculate and file their own taxes, there are numerous professionals in accounting that specialize specifically in cryptocurrency related taxes. Often they’ll be able to make use of rules and loopholes related to crypto capital gains that the everyday trader wouldn’t know how to properly utilize, so you may be able to save more than you would have attempting to file your crypto taxes alone.
I should emphasize that not everyone needs to hire an accountant for this sort of thing. Part-time traders, or those dealing purely with small amounts of currency may find that the price of an accountant far offsets any savings they could get by using their services.
You aren’t likely to be facing jail for some minor tax infractions any time soon. Nevertheless, the little inefficiencies and small slip-ups new traders routinely find themselves making are well worth avoiding. Doing so can keep you and your assets safe, and as profitable as you can be.
This article is not financial advice. The content above is strictly the opinion of the author. Do thorough research before investing in any asset.
This content is brought to you by Maxim Panych.