Chapter 10

Amending Past Tax Returns On Crypto Taxes

The good news is that taxpayers can amend past tax returns and include cryptocurrency taxes. The American tax system relies primarily on a compliance system that is voluntary. Therefore, the IRS expects citizens to report all of their taxable transactions. A failure to do so can attract heavy penalties and even criminal prosecution.

How Does The IRS Know That A Taxpayer Owes?

There are a few ways in which the IRS can determine if one has taxable cryptocurrency transactions or not. For instance, if after a crypto exchange the taxpayer receives a Form 1099-B or Form 1099-K, then the 'matching mechanism' in the IRS Information Reporting Program will highlight this. Also, if the crypto exchange receives a subpoena from the IRS then they may be required to disclose user account details. Therefore, if one has exchanges, spent, or sold cryptocurrency in the past, then it is important to report them as crypto tax for that year without fail.

How To Include Past Tax Returns?

The IRS allows taxpayers up to three years to claim any refunds or losses. While most IRS audits take the past three years into consideration, some can go even further back. In case a taxpayer has not reported past years' crypto transactions in the tax filing, then this can be done in the following manner,

Step 1 - First they need to calculate how much is owed in crypto taxes in terms of capital gains. Tax preparation software platforms like TaxAct or TurboTax can be used to arrive at accurate calculation and manage amended tax.

Step 2 - The next step is to amend one's tax return after calculating the overall capital gains liability. This amendment can be done using the IRS Form 1040X. It is a self-explanatory form and requires only information that is updated or new.

Step 3 - Once the form is completed the taxpayer mails this form to the IRS as the amended tax return. It is essential to attach all the required supporting documents to make sure that the form is complete in every aspect.

In the case the amended tax liability is a higher amount, then one must include the additional payment while sending across the amendment to the IRS. Also, it is important to know the Fair Market Value of all trade transactions for retrieving capital gains or losses. While this may not be an issue in case the transaction volume is low but can soon become an issue in case of large volumes. Therefore, it is recommended to file for crypto taxes in the same financial year.

Summary

Calculating and paying taxes can often seem like a tedious task, however, it is essential to incorporate all cryptocurrency transactions while filing annual tax returns. Even though it may seem that crypto transactions have an extremely decentralized and anonymous nature and the IRS may not have clear visibility on all cryptocurrency transactions to know whether the traders are generating revenues or not, this is certainly not the case.

There are enough and more software products in the market to help traders in the crypto tax filing process. These can be easily employed to ensure that one remains on the right side of the annual tax filing regime.

Advanced Crypto Tax Situations

Simple cryptocurrency transactions are easy to file tax against, even when trading major coins or large exchanges. Users can choose from various tax filing platforms and employ convenient software applications to file crypto taxes. However, it is always possible for a trader to become involved in complex situations where possessing an advanced crypto tax knowledge can be beneficial. Simple crypto trading situations can turn complex if the ICO invested in is no longer tradable, or coins are lost in case of a hacked exchange. It is essential for a trader to understand such tricky situations and know how to deal with them.

DeFi Crypto Tax

DeFi stands for Decentralized Finance. Some of the popular DeFi products include lending and borrowing markets, decentralized exchanges, derivatives, payment networks, tokenized physical assets like gold, etc.

In a nutshell, DeFi helps the trader earn interest on the lending of their cryptocurrency or allows them to use their cryptocurrency as collateral for taking out loans. Additionally, there is no middleman as these crypto lending platforms operate on smart contracts. Therefore, the nature of the transaction is more direct and allows anyone holding this currency to initiate a borrowing or lending activity.

How Is DeFi Crypto Taxed?

DeFi crypto attracts different tax liability and advantages depending on whether the trader is lending or borrowing. This difference is explained below.

Lending

For a crypto lender, the tax liability is calculated on the amount of interest earned on a crypto loan. The interest earned is subject to the same rates as income tax depending on the fiat value of the cryptocurrency earned. As an example,

  • Interest payout= 0.01BTC

  • BTC is trading at 8,000 USD per coin.

  • Equivalent income earned = $80

This income of $80 will be taxed at the same rate on income tax as is applicable for the individual's other wages or income.

Borrowing

While Crypto lending attracts tax on the interest earned, crypto borrowing can translate into important tax advantages. If one type of cryptocurrency is used as collateral to borrow another type, then there is no tax realization on that particular cryptocurrency which is set as collateral. Cryptocurrency can be borrowed and even converted into flat and will not be taxed.

Cryptocurrency will only be under tax implications if it is exchanged or sold. In other words, one can pay taxes without attracting additional taxes when selling the cryptocurrency.

Tax-Loss Harvesting Using The Holding Period

Holding onto cryptocurrency can help reduce tax liability from capital gains. This is the underlying premise of the tax-loss harvesting strategy. While this has already been discussed earlier, there are certain risks that the taxpayer must be aware of.

Risks Involved In Tax-Loss Harvesting

While tax loss harvesting is allowed, it is not without its own share of risks. For instance, as a crypto trader, one must be vigilant to avoid any 'wash sale' possibilities. According to the IRS, a trader cannot claim a loss on the sale of particular security if it is bought back within a 30-day period.

Therefore, it is recommended to wait at least 30 days before venturing into a buyback of cryptocurrency after recognizing a loss on the same.