Made a killing in crypto? Your tax bill is coming due

If financial advisers have clients who made a killing in crypto last year, they may want to remind them the tax bill is due. The challenge will be in calculating it.

Cryptocurrencies like Bitcoin and Ethereum are classified as property by the Internal Revenue Service and taxed like stocks and bonds.

“They hear ‘currency,’ and they think it’s like cash,” said Nancy Dollar, senior counsel at Hanson Bridgett. “People don’t realize, ‘Oh, I have to calculate what my gain is and what my loss is.’ It can be confusing to taxpayers.”

It can also be a shock. When investors trade crypto — or when they use it to buy goods or services — they're engaging in transactions that have tax consequences.

“Crypto trading is not tax-free,” Dollar said. “It definitely can be a surprise at the end of the year, especially if you’re not a seasoned investor. There are probably a ton of people trading casually who rack up big gains and aren’t prepared for the tax hit later on.”

Most cryptocurrency investors are new to the market, according to a report released in December by Grayscale Investments. The study showed that more than half of investors who owned Bitcoin began buying it within the last year.

As demand for crypto rises, the people who are getting into the market are probably thinking about their returns rather than the taxes they must pay on the gains.

“The vast majority either don’t know or don’t care,” said Toby Mathis, a partner at Anderson Business Advisors.

One of the biggest challenges for crypto investors is tracking gains and losses, which has to happen after every trade for what could be a multitude of transactions over the time of the investment. The IRS also assumes that crypto is traded when it’s used to buy something, such as a car.

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When stocks are bought, sold and reinvested, brokerages keep track of the capital gains and losses. Crypto exchanges don’t do that. Investors are on their own.

“The record keeping is problematic,” said Rob Cordasco, founder of Cordasco & Co. “It hasn’t caught up with the complexity of these activities. The onus of that record keeping will always fall to the taxpayer, unfortunately.”

Financial advisers can help their clients by reminding them about the tax side of crypto investing.

“The question to ask is, 'What is your plan for basis tracking?'” Dollar said.

If investors aren’t able to fully report their crypto gains, it’s not clear what kind of trouble they could be in with the IRS because the agency doesn’t have its arms around the crypto market, Mathis said.

“The IRS is completely undermanned and behind the eight ball as far as understanding the technology and having any reasonable means to enforce the law,” Mathis said. Crypto activity “is no different than a cash transaction. They’re hoping the taxpayer reports it.”

But if the IRS manages to catch crypto tax cheats, the agency will likely punish them, he said. “My guess is they’re going to prosecute some of the crypto people to set an example.”

The IRS' ability to monitor crypto tax liability could improve soon. The infrastructure bill signed into law earlier this year included a provision to require crypto exchanges to report purchase prices, gains and losses to the IRS, generating the same type of information that brokerages report on Form 1099.

“We expect crypto to follow the same path,” Cordasco said.