Cryptocurrency can be an amazing tool and investment with great potential. The tax rules can get pretty complicated. Many crypto investors are facing a harsh reality: widespread failures in crypto tax reporting. These glaring failures expose millions of taxpayers to unnecessary risk of audit, penalty, and even criminal prosecution. This blog discusses what makes these projects fail and provides guidance on how taxpayers can protect themselves.

Rest assured, the IRS is pursuing cryptocurrency tax compliance with the utmost rigor. Amplified by heightened scrutiny and ’gotcha’ enforcement, the risks associated with erroneous reporting are stiffer than ever. Hoping for the best is not cutting it anymore. That means crypto investors need to go out of their way to ensure they’re prepared to pay their taxes. Knowing the most common pitfalls and knowing what resources are available to help is key to navigating this complicated landscape.

The systemic failures of crypto tax reporting “faulty, confusing and self-serving” for a number of reasons. Platforms and exchanges typically use worst-case scenario math. The complexity of crypto transactions, combined with the crypto industry’s lack of standardization only exacerbates this confusion. Until these nonprofit administration problems are fixed, far too many hardworking taxpayers will remain in peril of receiving the unwanted scrutiny from the IRS.

The Root Causes of Crypto Tax Reporting Failures

There are a number of reasons related to this widespread lack of success with crypto tax reporting. These problems range from technological limitations to a void of clarity and standardization across the sector. Here are some of the major reasons for these breakdowns—let’s take a look.

Platform and Exchange Inaccuracies

Because crypto platforms and exchanges tend to undersell and overcomplicate these calculations. These errors are often the number one culprit for mistakes in crypto tax reporting. These platforms have become the bedrock of transaction data for taxpayers. As such, any mistakes they make can result in deadly outcomes.

We know that crypto transactions are often much more complicated – including steps such as buying, selling, trading, and staking crypto. This lack of uniformity creates a confusing environment for platforms to reliably determine tax liabilities. For one, each platform likely utilizes different approaches to determine tax liabilities, resulting in further inconsistencies and inaccuracies. When a taxpayer has a large number of transactions, it is even more challenging for a transaction-based platform to calculate accurate tax liabilities. This challenge is exacerbated when the platform is unable to access robust or accurate data. The absence of standardization and the failure to collect robust data can lead to misleading reporting. This can cause unintentional violations of IRS guidelines, which can subject these nonprofits to audits, penalties and fines.

Complexity of Crypto Transactions

Further complicating tax reporting is the nature of cryptocurrency transactions themselves. Unlike traditional financial transactions that usually have one or two steps, one platform, and one asset, crypto transactions can be much more complicated.

Indeed, even a straightforward trade of one digital asset for another can make you liable for taxes owed. Staking rewards, DeFi lending and liquidity pool participation each bring their own specific tax implications. It might seem daunting keeping track of all these transactions and determining what your gain or loss is on each one. This is doubly true for people who are not tax experts. That complexity in these transactions is a huge obstacle to accurate tax reporting.

Lack of Standardization

The fact that there is no standardization across the crypto industry only compounds the issue. Each platform has its own specific way of calculating cost basis, tracking transactions, and reporting income. This lack of uniformity is a huge burden to taxpayers. This has caused them to have to scramble to reconcile their records and know what is being reported for taxes.

Without robust standards, it is taxpayers who are forced to walk the tightrope of contradictory information and varying practices. This lack of standardization is the primary reason why 90% of all crypto tax reporting is incorrect.

Common Crypto Tax Reporting Mistakes

This has led a growing number of crypto investors to accidentally commit tax reporting errors. These mistakes can be from innocent oversights to more nefarious ignorance of the tax statutes as a whole. Being aware of these pitfalls is the best way to make sure you avoid them.

Failing to Track Cost Basis Correctly

One of the biggest pitfalls we see is not being able to track cost basis properly. In other words, cost basis is the original price you paid to acquire an asset. It’s extremely important when calculating your capital gains or losses when you sell or otherwise dispose of that asset.

Failure to use appropriate or beneficial cost basis methods can cause devastating outcomes. For example, choosing FIFO (first-in, first-out) instead of specific identification can double or triple your tax bill. And if you didn’t dollar cost average, using FIFO would result in a larger Bitcoin tax liability. Instead, tracking which coins you sold can help you pay less in taxes. Maintaining detailed records of your purchase prices and dates will make it easier for you to determine the correct cost basis.

Forgetting to Report Staking and Mining Rewards

It’s a common mistake many investors violate the rules on. These rewards are treated as taxable income by the IRS but they remain an underappreciated or misinterpreted aspect of the rewards.

The reality is, when you earn staking or mining rewards, you are earning income in cryptocurrency. That income is taxable to you at its fair market value when you access it. Not reporting this income can make you guilty of underreporting your tax obligation and in danger of penalties. Most importantly, you need to record each and every staking and mining reward you earn and report it on your tax return.

Not Reporting All Transactions

Maybe the biggest overall pitfall of them all – not reporting any or all of your cryptocurrency transactions. This extends beyond simple sales and purchases to the space of trades and swaps — even micropayments.

Almost every cryptocurrency transaction, even swapping one cryptocurrency for another, is a taxable event. Even if you did not make a profit, you are nonetheless obligated to report the transaction. Neglecting to report all your taxable transactions can result in a confusing and misleading return, increasing your risk of audit. Covering any and every transaction is a vital element of proper tax reporting.

The Risks of Non-Compliance

Fines for tax evasion can amount to 5 years in prison and $250,000 in penalties individually. The IRS is currently enforcing against cryptocurrency tax compliance and the stakes of non-compliance are high.

Audits and Penalties

The first and perhaps most tangible danger of not being in compliance is being subjected to an audit. If the IRS believes that you’ve found a way to underreport your crypto income, they will likely start an audit. They’ll analyze your supporting documentation to identify any mistakes made on your tax return.

If the audit concludes that you have, in fact, failed to pay your taxes, you can face significant penalties. These penalties can be substantial, ranging from the imposition of various fines and interest charges to criminal prosecution in extreme situations. Tax reporting done WRONG The potential cost of non-compliance can start adding up fast, so accurate tax reporting is an absolute necessity.

Potential Criminal Prosecution

In the most extreme examples, not reporting crypto taxes may be met with criminal prosecution. The IRS is more willing to intervene if they believe you willfully attempted to avoid paying taxes. They’ll go deeper if they think you’re trying to conceal income.

Conviction on a criminal charge carries the threat of heavy penalties, including fines, jail time, and a lifetime criminal record. While criminal prosecution is extremely rare, it is possible. Those who willfully ignore tax laws can and should be treated with the utmost severity.

How to Protect Yourself

The crypto tax landscape can be intimidating, but you don’t need to navigate it by yourself. Follow these basic guidelines to avoid identity theft and still make the right IRS payments.

Accurate Reporting

So what is the true foundation of crypto tax compliance? Accurate reporting. For most taxpayers, this will involve tracking sales of cryptocurrency very carefully and reporting capital gains and losses accurately on your tax return.

Require cryptocurrency platforms to report users’ earnings to the IRS, and through them, to taxpayers on their return. This means declaring every bit of income that you earn, every gain and loss that you realize from your crypto trades. When you focus on getting it right the first time, you reduce the chance of mistakes and subsequent consequences.

Maintain Records

Keeping good records of your crypto transactions is the best way to ensure you’re ready to accurately report your crypto on your taxes. That’s everything from tracking every crypto exchange and wallet you own to every blockchain and DeFi platform you’ve used.

Maintain comprehensive records for each cryptocurrency transaction, across exchanges, wallets, and platforms. This provides you with a comprehensive look at your crypto activities. It will make your tax liabilities relatively easier to calculate. Accurate and thorough record-keeping is important for showing compliance to the IRS.

Understand Tax Laws

Understanding the tax laws and regulations that apply to cryptocurrency is crucial to preventing costly errors and ensuring compliance with the IRS. You’re well-versed in IRS guidance such as Notice 2014-21. This notice provides interim guidance on the treatment of virtual currency in tax revenue.

Learn tip tax each apply laws and regulation governing whereabouts cryptocurrencies, including Notice 2014-21. To keep up on the latest news in crypto tax law, with this information, you’ll be equipped to make informed investment decisions and avoid common missteps.

Seek Professional Help

If you’re feeling lost about the right way to report your crypto taxes, reach out for professional assistance. A knowledgeable tax professional can provide personalized guidance and ensure you are meeting your tax obligations.

Work with a qualified tax professional to stay compliant with complex federal and state tax laws and regulations. A tax professional can help you navigate the complexities of crypto tax law and minimize your risk of errors and penalties.

Leveraging Crypto Tax Software

One of the most effective ways to simplify crypto tax reporting and ensure accuracy is to utilize crypto tax software. These tools are designed to help you automate the bulk of tedious tasks that go into calculating your tax liabilities.

CoinLedger

CoinLedger is the leading crypto tax software, letting you automatically import transactions from hundreds of blockchains and exchanges. This streamlines the process of collecting and storing data, minimizing the potential for human error.

Automate crypto tax reporting and ensure accuracy by using crypto tax software like CoinLedger. Tools like CoinLedger can help you reclaim your time and energy. They offer a truer and more complete picture of your tax liability.

Syncing with DeFi Swaps and Protocols

If you’re active in DeFi (Decentralized Finance), keeping track with DeFi swaps and protocols is key to reporting your taxes correctly. Which helps you automatically track all your DeFi transactions so you can know your gains and losses.

This is where using software with automatic sync capabilities for DeFi swaps and protocols comes into play to simplify tax reporting and reduce costly mistakes. This is especially key for DeFi investors who often have hundreds of convoluted transactions.

Crypto Tax Software for DeFi Investors

Fortunately, specialized software specifically designed for DeFi can ensure that DeFi investors report their taxes with 100% accuracy. It figures gains, figures cost basis, and completes tax returns. These tools come equipped to address DeFi tax reporting’s distinctive hurdles.

Specialized software that calculates gains, determines cost basis, and prepares tax returns can help DeFi investors accurately report their taxes. All of these tools can keep you compliant and on the cutting edge of the DeFi revolution while preventing unwanted IRS attention and penalties.

Form 8949

Token for token swaps on decentralized exchanges, where you exchange one cryptocurrency for another, are loggable using Form 8949. Filling out this form properly is critical in getting your crypto transactions reported to the IRS properly.

One simple tax form records all sales and exchanges, even token-for-token swaps on decentralized finance exchanges (DeFi). Completing this form helps us with proper tax reporting. Knowing the proper use of Form 8949 is the key to reporting your crypto transactions correctly and avoiding issues.

Layer 2 Solutions

Using Layer 2 solutions such as Polygon and Arbitrum have become a popular alternative for accessing DeFi due to their significantly lower fees and faster transaction times. Tax reporting is a complex function that must be done right.

Layer 2 solutions such as Polygon and Arbitrum can reduce fees by orders of magnitude in addition to increasing transaction speeds for DeFi. It’s important that tax reporting be done properly. Don’t allow the newfound convenience of using Layer 2 solutions to let you forget about your tax requirements.

Taxing cryptocurrency transactions accurately can be a complicated and ever-changing process. The massive failures from the crypto industry on tax reporting have left millions vulnerable to unsolicited audits, penalties, and even possible criminal prosecution. Learn from the root causes of these failures to not repeat common pitfalls. Take advantage of tools such as crypto tax software and professional advice to defend yourself and adhere to your tax requirements. With the IRS cracking down on crypto tax compliance, now more than ever is the time to focus on getting it right and request assistance if you’re unsure.