Updated NOVEMBER 02, 2023

IRS Crypto Audit: What to Do When the IRS Sends You a Crypto Letter

Did you receive an IRS letter proposing a HUGE amount due on your cryptocurrency transactions?

Are you being audited by the IRS for your crypto transactions?

Often, these letters say in big, bold letters on the first page: “Proposed amount due: $__,___”.

One of our clients recently received such a notice from the IRS claiming that he owed a whopping $10,835 on just a few cryptocurrency transactions he made through Cash App!

This particular notice our client received was a Notice CP2000 (though you may have received a different notice type) and although it’s not technically an audit, it kind of functions like one because the IRS is saying that, contrary to what you put on your tax return, it thinks you owe a lot more.

Here is what the first page of our client’s IRS crypto letter looked like:

IRS Proposed Amount Due on Cryptocurrency Transactions

Then, later on, this notice listed out several cryptocurrency transactions our client made; here are a few of them:

IRS Explanation of Changes for Cryptocurrency Transactions

These were all bitcoin sales that our client made through Cash App (which is owned by Block, Inc. as shown on the notice).

Of course, we’ve had other clients for whom this notice listed out transactions from other platforms such as:

  • BlockFi
  • Voyager
  • Kraken
  • And more

Why Is the IRS Auditing Your Crypto?

See, all of these companies report your cryptocurrency sales — as in your gross proceeds — on Form 1099-B, filing this form with the IRS and sending you a copy.

However, what these platforms don’t report to the IRS is how much you paid for this cryptocurrency — your cost basis.

So if you didn’t report these cryptocurrency transactions on your tax return, the IRS will audit your crypto and even recalculate your tax liability for you without giving you credit for what you paid for the cryptocurrency.

And you can see that right there in your notice! Look at this image again; those figures in the second column — $10,097; $15,607; and $6,587 — were our clients gross sales price when he sold his crypto; they’re not his net gain.

IRS Explanation of Changes for Cryptocurrency Transactions

Yes, the IRS is attempting to tax you on your gross, not your net!

And that’s why these IRS crypto audits are so crazy!

Why IRS Crypto Audits Are So Crazy

Yes, these IRS crypto audit notices can be incredibly shocking — and wrong!

This is because in the proposed amount the IRS wants to collect from you is often extremely overstated.

You Can Actually Have a Crypto Loss…

So let’s say that you engaged in two cryptocurrency transactions during the year:

  1. You bought five BTC for $300,000 (or $60,000 per bitcoin).
  2. You paper-handed and sold all five BTC for $200,000 (or $40,000 per bitcoin).

So in reality, you had a $100,000 loss since you bought all your bitcoin for $300,000 but then sold them all for only $200,000, and you would not owe any taxes on these transactions.

…But the IRS Will Consider It a Gain!

However, unless you reported to the IRS how much you paid for your bitcoin on your tax return, the IRS will simply assume that you paid absolutely nothing for your bitcoin and that you have a taxable gain of $200,000 — your gross proceeds when you sold your bitcoin.

And they will send you an IRS crypto letter stating that they are proposing to assess an astronomical amount of tax on your bitcoin sales!

This is why these IRS crypto audit letters are so often wrong.

What To Do If the IRS Is Auditing Your Crypto

If the IRS is auditing your crypto, you need to take the following steps.

These are the steps we take when we are hired to represent somebody in their crypto audit.

Step 1: Understand which transactions the IRS thinks you didn’t report.

This is very easily done by flipping through the notice and looking for the list of transactions.

These transactions will typically be listed out in the section of the notice titled “Explanation of changes to your Form 1040.”

Step 2: Confirm that you actually didn’t report these transactions correctly on your return.

This will probably come as no surprise to you, but the IRS does make mistakes.

And I’ve personally seen it where the taxpayer reported things correctly on their tax return, but the IRS still sent them a notice claiming they didn’t.

So you want to confirm that what the IRS is saying on this notice is true.

If there are some transactions that the IRS is claiming you didn’t report but you actually did, note them because you will bring them up when you write your response to the IRS, which is a future step.

Step 3: Gather your crypto documents and other files for the transactions you didn’t report on your tax return.

So assuming that there were in fact some crypto transactions that you didn’t report on your tax return, you must now begin the process of gathering all of the necessary information you need to calculate your actual crypto gain or loss on these transactions.

BlockFi Example

So let’s say you made all your sales on BlockFi (RIP). If you also purchased all of your cryptocurrency on BlockFi — meaning you deposited fiat into BlockFi and then within BlockFi purchased bitcoin — and then you sold that bitcoin on BlockFi which gave rise to the 1099-B, this isn’t going to be that bad; all you need to do is export your BlockFi transaction history.

Coinbase and BlockFi Example

But if you bought the bitcoin on Coinbase and then transferred it to BlockFi and then sold the bitcoin on BlockFi, you’ll need both your Coinbase transaction history and your BlockFi transaction history because your BlockFi is not going to know what you paid for that crypto in Coinbase.

The Underlying Question

So the question you need to ask about each of your unreported cryptocurrency sales is, “Where did I buy this crypto originally and how did it get to the exchange where I ultimately sold it?”

You will need all of that paper trail in order to accurately calculate your gain or loss in these transactions.

This Can Get Complicated

And this can get very complicated because oftentimes with crypto the taxable event isn’t as straightforward as simply buying some bitcoin for fiat and then selling it for fiat.

For example, buying your bitcoin with fiat and then exchanging that bitcoin for ethereum is a taxable event, and your gain or loss is equal to the difference between the USD value of the bitcoin you exchanged for ethereum when you bought that bitcoin and the USD value of the ethereum you received in exchange for that bitcoin.

And then if you take that ethereum and transfer it to MetaMask and go on OpenSea and buy an NFT with it or mint an NFT with it, that’s a taxable event as well.

That being said, many transactions like this wouldn’t be reported on a 1099-B in the first place, and even so you are still required to report them on your tax return, but this is probably getting beyond the scope of this particular article because this article is strictly about the crypto transactions you didn’t report that the IRS knew about.

Bottom Line for This Step

So the bottom line for this step is that you need to pull all transaction data that affects essentially your basis in the crypto you sold in the transactions that the IRS is auditing you over.

P.S. — Fees are included in your basis.

Step 4: Calculate your actual gain or loss in these crypto transactions.

Now that you’ve gathered all the data, you need to go, transaction by transaction, and calculate the actual gain or loss on each of these transactions.

So you need to figure out which crypto assets you sold in each of these transactions and then trace your basis in those assets by looking at your data from the time you purchased them to the time you sold them.

And the difference between what you sold them for and your basis in them is your actual gain or loss for each transactions.

Another thing to note is for each transactions whether the sale is short-term or long-term; it’s short-term if you held the asset for a year or less, and it’s long-term if you held the asset for longer than a year. And long-term capital gains are generally taxed at a lower tax rate than short-term capital gains, so it’s good to trace that through as well.

This is all obviously easier said than done, and this is why you can hire professionals to do it for you.

Step 5: Recalculate your tax return including these transactions.

So now you know what the details of what you should have put on your tax return for these transactions; now you should actually go into your tax software you used to prepare your original return and input those transactions as though you had done your return correctly the first time.

Should You File an Amended Return?

So now you’ve prepared, after the fact, a tax return that includes the cryptocurrency transactions on the IRS notice that you didn’t report on your actual tax return that you filed.

And you may be wondering if you should simply file an amended return with the IRS at this point.

The answer to that question is generally no because the unit that handles the CP2000 if that’s the notice you got is the Automated Underreporter Unit, which doesn’t process amended returns.

And if you’re truly being audited, you don’t amend your return; you interface with your assigned revenue agent.

What If You Do File an Amended Return?

If you do file an amended return, it will simply be transferred to the appropriate unit, and you will be informed of this via Letter 86C.

Step 6: Determine what you actually owe the IRS or are owed from them.

Now that you know your actual tax liability for the year, you have the numbers you need to determine how much additional money you actually owe the IRS or they actually owe to you.

And the formula for this is simple; here it is:

“Amount You Owe” According to Your Recalculated Return
Plus Any Refunds You Received From the IRS After Filing Your Original Return
Less Any Payments You Made to the IRS While or After Filing Your Original Return

So let’s say that the “amount you owe” on your recalculated return is $10,000, but on your original return because you didn’t report a lot of crypto gains, you indicated that you were owed by the IRS a $2,000 refund, which they sent you.

Well, in that case, you would now owe the IRS $12,000 — the recalculated “amount you owe” on your recalculated return plus the refund you received from the IRS after filing your original return.

Note that the IRS will likely assess penalties and interest as well, which you can estimate if you know that the failure-to-pay penalty on the amount you didn’t pay by the due date is 0.5% per month and the current IRS interest rate on underpayments is 8%, though it was 7% earlier this year (the IRS interest rate is adjusted quarterly).

Step 7: Put together your written response and fax it to the IRS.

Finally — assuming you received a Notice CP2000 from the IRS concerning your cryptocurrency — you need to write a letter to the IRS and fax it to the number on the CP2000 you received, along with your recalculated return with “CP2000” stamped on top and any supporting documentation for what you’re saying in the letter.

Here are some guidelines as you put together this letter:

  • Be sure to include the following information in the heading of your letter:
    • Your name
    • Your Social Security number
    • The Automated Underreporter (AUR) control number indicated on the top right of your CP2000 Notice
    • The tax year you are writing about
  • If there are any items you agree with in the CP2000 Notice, mention it.
  • Also mention and describe the items you disagree with in the CP2000 Notice.
  • Provide a full explanation for why you disagree with the IRS’ proposed assessment of tax on these items and of course make sure that the figures in whatever backup documentation you provide match your explanation.
  • Ideally, you would — based on your recalculated return — also provide the IRS with the amount of tax you believe you owe for the items of income you earned but did not report on your original return.

Check out this article for CP2000 response sample letters you can base your letter off of.

Step 8: Wait for the IRS to respond.

The IRS AUR department will take some time to review your CP2000 response — typically around 90 days.

Two weeks after we fax our responses on behalf of our clients, we call IRS AUR to confirm they received our response — and then we just wait for them to respond.

Step 9: Provide any additional information the IRS requests.

The IRS AUR department may want more information from you to make a determination about your crypto case.

A common notice AUR sends to request additional information in these situations is Letter 2626-C.

If you receive this letter — or any other request from the IRS for additional information — provide it to them promptly.

Step 10: Look out for the closing letter.

Here are common closing letters:

  • Letter 1802-C: This is a closing letter the IRS uses when it closes your underreporter case with a proposed assessment — hopefully it matches the figures you presented to them in your response letter!
  • Notice CP2005: This is a closing letter the IRS uses when it is closing your case with no change to the tax liability you originally reported on your return.