We all read the headlines. Virtual currencies are a hot button topic. Even Facebook is developing their own virtual currency. It is easy to understand the attraction. The use of a virtual currency is anonymous. Account holders are protected behind private passwords and encrypted files. Or so we thought.

Over the next few months the Internal Revenue Service (“IRS”) will mail out over 10,000 letters to cryptocurrency and virtual currency account holders. The notices will encourage investors to report cryptocurrency and non-crypto virtual currency transactions that were either missing or filed incorrectly on their 2013 through 2017 federal tax returns.

The letters will have three variations: Letter 6173, Letter 6174, and Letter 6174-A (collectively “The Letters”). The Letters are designed to help taxpayers understand their tax and filing obligations including how to correct past errors.

For federal tax purposes virtual currencies are treated as property. As a result, the sale or exchange of a currency triggers the reporting of a capital gain or loss. How to report that capital gain or loss is dependent on the facts and circumstances surrounding the account holder’s involvement with the activity.

Unfortunately, accurately reporting virtual currency capital gains or losses is not always an easy task. Often, trading platforms do not provide a summary of capital gains or losses to the account holder. As a result, investors are forced to scour through pages and pages of transactions to calculate capital gains and losses. Also, due to errors in the application of inventory methods, the basis of the virtual currency being exchanged is often calculated incorrectly.

To further complicate the issue, virtual currency traders routinely leverage one virtual currency to purchase another. An example would be using a Bitcoin to purchase Ethereum (ETH), Monero (XMR), or Ripple (XRP). To accurately report the capital gain or loss the investor must apply the exchange rate between two currencies and apply the appropriate inventory method.

Other important items to note:

1. Depending on where the cryptocurrency account is held and the value of the account, filing a Report of Foreign Bank and Financial Accounts (FBAR) with FinCEN may be required.
2. Receiving virtual currency for goods and services performed is a reportable transaction.
3. The successful mining of virtual currencies must be included in gross income based on the fair market value of the currency and the income may be subject to self-employment tax.
4. Soft and hard forks require additional income and basis considerations.
5. Gifting a virtual currency may have additional reporting requirements.

To minimize tax, penalties, and interest account holders should respond to The Letters as requested and if necessary request additional time to do so. Delinquent or missing tax returns should be filed. Tax returns that were filed but are missing information may need to be amended. Failure to comply can lead to audits and/or criminal investigations.

Amending previously filed tax returns and filing delinquent tax returns is complicated. Accurately reporting cryptocurrency transactions is complex. Taxpayers who are keen to avoid any unnecessary run-ins with the IRS should closely follow the instructions in The Letters and consult with a tax attorney. As disappointed as cryptocurrency holders might be with the IRS’s enthusiasm in taxing these assets, avoiding penalties and criminal investigations has to be at the forefront of consideration. Rest assured, the increased level of compliance is not going away anytime soon.