Whether you're ready or not, we're right in the thick of tax season.
For many Americans, tax season is something of a double-edged sword. On one hand, preparing your taxes can often be a confusing, tedious, and borderline hair-pulling experience. Prior to overhauling the tax code via the Tax Cuts and Jobs Act, which will factor into your tax filing next year, the U.S. tax code had been expanding by an average of 144,500 words a year for roughly six decades. This made keeping up with tax law changes almost impossible, even with the assistance of a tax professional or tax software.
On the other hand, tax season usually sees tens of millions of Americans walk away with an average federal refund of between $2,700 and $3,100. Though getting a large refund is often not a smart move, this money typically goes a long way to boosting savings rates, as well as fueling sales growth at retailers, which helps the consumption-driven U.S. economy.
Taxpayers are doing a really bad job of reporting cryptocurrency transactions
This year, however, there's a relatively new complication for taxpayers and the Internal Revenue Service to be wary of: cryptocurrency capital gains. You see, the IRS considers digital currencies like bitcoin, Ethereum, Ripple, and Litecoin to be property. That means when they're bought and sold, you should be claiming profits and losses as a short-term or long-term capital gains or losses, depending on how long the investment was held (short-term holdings include everything held for 365 or fewer days). Rarely, though, are these transactions reported.
According to data from the IRS, between 800 and 900 taxpayers per year reported cryptocurrency capital gains on their federal income-tax filings between 2013 and 2015. Yet, based on a recent IRS legal victory over cryptocurrency exchange Coinbase, over 14,300 people traded in excess of $20,000 worth of bitcoin between 2013 and 2015. While not all of these folks may have made money, it certainly suggests that potentially less than 10% of those investors have accurately reported their profits to the federal government.
But if you think this filing rate is terrible, you haven't seen anything yet.
Get ready to laugh...
As Reuters reported on Feb. 13, fewer than 100 people out of the 250,000 individuals to have completed their federal tax filing through Credit Karma this year have reported cryptocurrency transactions to the IRS. That's less than 0.04% of all taxpayers. Understandably, virtual currencies aren't the easiest to invest in since users have to make purchases on decentralized exchanges, so this figure wouldn't be expected to be that high. Still, a 2,000-person survey from credit score start-up and research firm Qualtrics in January found that 57% of those Americans it surveyed had recognized some gains from cryptocurrencies. Fifty-seven percent versus less than 0.04% simply doesn't add up.
Why the massive discrepancy in these percentages? Well, it's not out of the question that those taxpayers with more complex filing situations are waiting to file later in the tax season, or are in the process of reconciling a year's worth of financial data.
Furthermore, it's not guaranteed that cryptocurrency exchanges will supply their users with profit and loss statements, or statements that provide a cost basis. And if they do, it's unclear if those members have received those detailed profit and loss statements as of Feb. 13. There really is no precedent to digital currencies, and since cryptocurrency users' identities have the potential to be obfuscated or conducted under pseudonyms, it makes tracing a transaction back to an individual difficult to nearly impossible.
There's also the real possibility that taxpayers are blatantly committing tax fraud by not reporting their transactions, crossing their fingers, and hoping for the best. A LendEDU survey in November of 564 bitcoin investors found that only 64% intended to report their capital gains or losses on their 2017 taxes. Essentially, it means more than a third purposely plan to commit tax fraud.
The IRS and Congress step up cryptocurrency capital-gain enforcement
Being well aware of the complications cryptocurrencies present, the IRS and Congress are beginning to put their foot down. As noted, the IRS won a legal case against Coinbase that gave it information on more than 14,300 users who may have evaded paying capital gains tax. But the biggest change arguably comes from Congress.
The passage of the Tax Cuts and Jobs Act in December killed a long-standing cryptocurrency tax loophole known as the like-kind exchange, as of Jan. 1. Before that date, cryptocurrency investors could exchange their bitcoin, Ether, Litecoin, or other virtual tokens for other virtual tokens without paying capital gains tax. They were making what was considered a "like-kind exchange." However, the new tax code replaced the word "property" with the phrase "real property," meaning any exchange of one digital currency for another would count as a capital gain or loss, and it would have to be reported.
It also meant that users would have to report capital gains if using their virtual currencies to buy goods or services. Imagine you purchased $1,000 worth or bitcoin, and bitcoin goes up in value. If you use $100 worth of your bitcoin on a good or service, the IRS will be expecting you to pay capital gains tax on that purchase. It's a complicated, but very much needed, modification to like-kind exchanges and cryptocurrency tax law.
It'll certainly be interesting to see how many taxpayers report cryptocurrency capital gains when all is said and done this tax season.
Sean Williams has no position in any of the stocks or cryptocurrencies mentioned. The Motley Fool has no position in any of the stocks or cryptocurrencies mentioned. The Motley Fool has a disclosure policy.