Categories: Tax Law

Traders (or any taxpayer) may have heard the recent news that the IRS extended the filing deadline for 2020 taxes from April 15, 2021 to May 17, 2021. Traders (or any taxpayer), however, may be less aware about the tax implications surrounding cryptocurrency and IRS enforcement efforts.

Virtual currency, also known as cryptocurrency, was a popular asset for traders, investors, and consumers during 2020. Virtual currency, which the IRS defines as “a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value” (See IRS Notice 2014-21), has many different forms. The most well-known cryptocurrency is Bitcoin, which increased in value by 92.71% in 2019; 305.94% in 2020; and by February 17, was up 75.42% in 2021 (See Update on Cryptoassets as of February 17th, 2021 By, Van K. Tharp, PhD – Van Tharp Institute ). Other major cryptocurrencies that you may or may not have heard about are Ethereum; Neo; Iota; Litecoin; and Holo. Recently, Dogecoin gained publicity due to interest from Tesla CEO Elon Musk.

Regardless of your cryptocurrency preference, the meteoric rise in cryptocurrency values over the last few years means it is likely that many traders have reportable income. If you own or owned cryptocurrency and have realized or unrealized gains or losses, it is important to first determine whether you are a trader or investor.

As outlined in IRS Topic No. 429 Traders in Securities (Topic No. 429 Traders in Securities (Information for Form 1040 or 1040-SR Filers) | Internal Revenue Service ( ) special rules govern traders, and the IRS considers trading to be a business if the following conditions apply:

  • You must seek to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation;
  • Your activity must be substantial; and
  • You must carry on the activity with continuity and regularity.

The IRS also considers the following factors in determining whether a taxpayer has a securities trading business: typical holding periods for securities bought and sold;

  • The frequency and dollar amount of your trades during the year;
  • The extent to which you pursue the activity to produce income for a livelihood; and
  • The amount of time you devote to the activity

Generally, the IRS views cryptocurrency as property, and applies property transaction principles to cryptocurrency transactions. (See IRS Notice 2014-21). Traders are required to report their business expenses on Schedule C of Form 1040, and their gains and losses are not subject to self-employment tax. In order to treat gains and losses from the sale of securities as ordinary income, traders must elect to use the mark to market rules under IRC Section 475(f). Traders using the mark to market rules are not subject to the limitations on capital losses or the wash sale rules. Traders interested in using the mark to market method must do so by following the specific instructions set forth in IRS Topic No. 429 (click on the link above to view).

In 2014, the IRS issued its first notice on the tax treatment of cryptocurrency. In 2019, the IRS sent letters to virtual currency owners (Letter 6173; Letter 6174; or Letter 6174-A) “to address tax noncompliance related to the use of virtual currency.” (See IRS has begun sending letters to virtual currency owners advising them to pay back taxes, file amended returns; part of agency’s larger efforts | Internal Revenue Service). In the same press release, the IRS made it clear that “Virtual currency is an ongoing focus area for IRS Criminal Investigation.”

In 2020, the IRS moved a question about cryptocurrency from Schedule 1 of Form 1040 to the first page of Form 1040, and it is not a coincidence that the question is right below the taxpayer’s name and address. The location of the question indicates that the IRS plans to raise awareness of the tax implications for owning cryptocurrency and enforce the reporting of cryptocurrency transactions. In 2020, the IRS also hired cryptocurrency experts as contractors to assist them with identifying and auditing tax returns that omitted or incorrectly reported cryptocurrency transactions. In March 2021, a United States District Court issued an order upholding the use of a summons by the IRS to obtain records regarding a taxpayer’s cryptocurrency transactions from Coinbase. (See this blog post from Coinbase for helpful information and resources)

What can happen if a trader (or any taxpayer) owns virtual currency and does not disclose it or incorrectly reports it?

The IRS can audit the taxpayer and impose information reporting penalties or accuracy related penalties on the trader (or any taxpayer). These penalties can be substantial and range from 20% to 75% of the unreported or underreported income. Typically, the IRS assesses the 75% penalty in cases that involve fraud, which means it is important to accurately answer the question on the Form 1040. Moreover, traders (or any taxpayer) are responsible for keeping cryptocurrency records, but the IRS only generally defines them as “records documenting receipts, sales, exchanges, or other dispositions of virtual currency and the fair market value.” (See Frequently Asked Questions on Virtual Currency Transactions | Internal Revenue Service (