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If there’s one thing the federal government likes more than protecting citizens, it’s collecting revenue. Last month, the IRS announced they will be sending 10,000 letters to cryptocurrency HODLERs and holders that traded digital currency in the USA.

The letters aren’t necessarily a bad thing.

They’re also not an empty threat.

Two Types of Letters

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The IRS’s interpretation of the tax code classifies cryptocurrency as property. Unfortunately, unlike real property, for example, there is no provision for a “like-kind exchange.”[1] That is where you defer tax on gains associated with property that you sell if you use those gains to purchase another similar piece of real property. The unfortunate (and common) effect is that when a person purchases cryptocurrency and has a 2000X gain; when they sell, they lock in their 2000X gain for tax purposes.

In an ideal world, the crypto-trader set aside some cash from the gain to pay their taxes. If instead, they use all funds from the sale to purchase more cryptocurrency, unless they have another source of cash to pay the taxes, they will need to sell cryptocurrency. Unfortunately, if, as in December of 2017, the market suddenly crashes, they will not have cash to pay their taxes. Sometimes the incurred losses can be set off against the gain, but that assumes perfect record keeping and tax preparation, and that the gain and loss takes place in the same year. The IRS is much better at finding gains than it is at finding losses.

Crypto-trader financial pinch aside, overall, the attention by the IRS is a step in the right direction. Although the lack of a “like-kind exchange” procedure is less than acceptable, we’re moving closer to crypto-acceptance by the powers that be. Progress will continue. For instance, the Token Taxonomy Act would address some of the taxation issues (as I argue here).

As to the current round of IRS communiques:

Austin Woodward, crypto taxation expert, CPA, and CEO of TaxBit, explains that:

“There are two different letters that were sent out. There is letter 6174, which is more of an educational letter. Then there’s 6173 which requires action, and lack of action can lead to an audit. It’s not dissimilar to the letters the IRS has been putting out for the last 100 or so years.”

It’s a confusing process; Austin anecdotally explains:

“We had a taxpayer call us in tears saying they received an audit later stating they owed $75,000. Apparently, Crypto Exchange A sent them a 1099-K which stated that amount. When they told us what happened, we were like, ‘hold up, we know exactly what Crypto Exchange A sends to the IRS, something’s not right.’ They don’t report cost basis, just gross proceeds. The IRS, not knowing, just takes the 1099-K and says we’re just assuming that’s all income. Since the exchanges only report gross proceeds, you need to itemize your trades. When we were done, we found that they had about $800 in taxable gains and only owed $200, but there’s still some correspondence between us and the IRS to determine the final amount,” Austin told me.

Message Sent, Message Received

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Receiving a 6173 or 6174 letter from the IRS is not an empty threat, but the larger purpose is more akin to viral marketing. The 10,000 letters were to get the conversation started. Every time, Forbes, Yahoo, all of the crypto-oriented web sites — even when your esteemed author weighed in — the IRS generated millions of impressions.

I think they made their point. That said, in doing so, they bring crypto-currency further into the light of day as an acceptable asset class. Pay your taxes, breathe, eat, trade, pay more taxes and so on . . . and continue the inevitable. With some clever application of blockchain technology, (perhaps also machine learning, Crisper, etc.), there’s a good chance that we will collectively beat death before we stop paying taxes.