What Happens if You Don't Report Cryptocurrency Capital Gains on Your Federal Tax Return?

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In 2017, cryptocurrency investors could seemingly have thrown a dart at any of the largest virtual currencies by market cap and walked away having made a significant profit. There were well over one dozen large digital currencies that soared more than 11,700% last year, including Ripple and NEO, which gained a respective 35,564% and 52,372%.

Operating in a relatively unregulated industry, these profits have been mostly pocketed by U.S.-based investors for years without much in the way of repercussions. In fact, an Internal Revenue Service (IRS) loophole known as the "like-kind exchange," which had allowed crypto investors to sell one virtual currency and put that money to work in other digital tokens (a like-kind exchange) allowed investors to completely avoid taxation as a result of technicality.

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The IRS and federal government aren't playing around with crypto taxation any longer

However, times are changing and the IRS is no longer playing around. With cryptocurrency market caps exploding in 2017, along with investor profits, Uncle Sam is intent on getting his fair share of capital gains tax in the current tax season. As a reminder, the IRS issued an announcement last month that reiterated what it said back in 2014, namely that cryptocurrency is considered property and that any sort of sale of virtual currency should be logged as a capital gain or loss. This means selling bitcoin to buy any other virtual coin, or even using your bitcoin to purchase a good or service online, is considered a taxable, and therefore reportable, event.

How do we know the IRS and federal government aren't fooling around anymore? In November, the IRS announced that it'd won a court case against well-known cryptocurrency exchange Coinbase that required the exchange to hand over information on 14,355 users who'd transacted in excess of $20,000 worth of bitcoin between 2013 and 2015. Considering that only 800 to 900 tax filings a year between 2013 and 2015 addressed cryptocurrency capital gains despite the IRS's announcement that they be treated as property, this pretty clearly shows that a lot of folks purposefully ignored the capital gains tax implications.

What's more, the Tax Cuts and Jobs Act, which was signed into law in December 2017, officially closed the tax loophole that allows crypto investors to use the like-kind exchange to sidestep taxation. With the IRS and federal government cracking down on crypto tax evaders, they now have no choices but to be up front with their capital gains and losses.

What happens if you don't report your cryptocurrency capital gains?

But what happens if cryptocurrency investors, despite the IRS' warnings, choose to purposefully hide their profits and fail to report their capital gains? It's not such a far-fetched idea considering that when online student loan marketplace LendEDU questioned 564 bitcoin owners in November about their tax strategy for 2018, only 64% responded that they'd be reporting their capital gains and losses. That means more than a third of the surveyed bitcoin investors are planning to commit blatant tax fraud.

Should crypto investors purposefully avoid reporting their capital gains and losses, the IRS can enforce a number of penalties, including criminal prosecution, which is only used in the most extreme circumstances. Tax evaders can face up to five years in prison, along with a fine of up to $250,000.

Furthermore, taxpayers who knowingly file a false tax return may face up to three years in prison, as well as pay a $250,000 fine.

As noted in the tax regulatory agency's March press release: "Taxpayers who do not properly report the income tax consequences of virtual currency transactions can be audited for those transactions and, when appropriate, can be liable for penalties and interest."

Of course, keeping track of your cryptocurrency transactions isn't always easy. There are no guarantees that decentralized cryptocurrency exchanges are going to send you a 1099 detailing your trades, cost basis, and profit or loss. Plus, if you used your virtual tokens to pay for goods and services, that's a taxable transaction you'll have to account for completely on your own.

Despite the complexity associated with crypto transactions, you're still expected to fully comply with IRS guidelines. If you don't, a big penalty, and possibly even jail time, could await.

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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.