Crypto Tax Mistakes That Trigger IRS Audits

The IRS considers cryptocurrency to be property, not currency, which means every transaction involving crypto can potentially trigger a taxable event. This includes selling crypto for cash, exchanging one cryptocurrency for another, using crypto to purchase goods or services, receiving crypto as payment for work, and earning crypto through mining, staking, or DeFi protocols.

The agency has invested heavily in blockchain analysis technology and has obtained records from major exchanges through court-ordered summons. In 2023 and 2024, the IRS sent tens of thousands of educational letters and CP2000 notices to taxpayers whose cryptocurrency activity did not match their tax returns. The IRS Criminal Investigation division has also made cryptocurrency tax evasion a priority, pursuing cases that result in significant penalties and even criminal prosecution.

Starting with the 2024 tax year, taxpayers must answer a specific question on their Form 1040 about whether they received, sold, exchanged, or otherwise disposed of any digital assets. Checking “no” when you actually had taxable crypto activity can be treated as making a false statement to the IRS, which carries serious consequences.

Failing to Report Exchange Transactions
Major cryptocurrency exchanges like Coinbase, Kraken, and Gemini report user transactions to the IRS using Forms 1099-MISC, 1099-B, and beginning in 2025, Form 1099-DA specifically for digital assets. When the IRS receives these forms but your tax return does not show corresponding income, their automated matching system flags your return for review.

Many taxpayers make the mistake of assuming that if they did not receive a 1099, they do not need to report their crypto activity. This is incorrect. You are legally required to report all taxable cryptocurrency transactions regardless of whether you received an information return. The IRS has access to exchange records beyond what appears on 1099 forms, and they are actively using this information to identify non-compliant taxpayers.

Misunderstanding Crypto-to-Crypto Exchanges
One of the most common misconceptions is that exchanging one cryptocurrency for another, such as trading Bitcoin for Ethereum, is not a taxable event. In reality, the IRS treats this as a sale of the first cryptocurrency followed by a purchase of the second. You must recognize gain or loss on the disposal of the first crypto, measured as the difference between your cost basis and the fair market value at the time of the exchange.

This catches many taxpayers by surprise, especially those who traded frequently during bull markets and accumulated substantial unreported gains. Even if you never converted crypto to dollars, you may owe significant taxes on your trading activity.

DeFi Protocol Confusion
Decentralized finance protocols have created entirely new categories of taxable events that many investors fail to properly report. When you provide liquidity to a DeFi pool, the IRS may treat this as a taxable exchange. When you receive tokens as staking rewards, interest, or governance incentives, these are generally taxable as ordinary income at fair market value when received.

Yield farming, liquidity mining, and other DeFi strategies often generate dozens or even hundreds of small taxable events that are difficult to track without specialized software. Many taxpayers either ignore these transactions entirely or report them incorrectly, creating significant compliance risk.

NFT Sales and Royalties
Non-fungible tokens present their own tax challenges. When you sell an NFT, you must recognize gain or loss just as you would with any other property sale. If you created the NFT yourself, the entire sale proceeds may be taxable as ordinary income. If you receive ongoing royalties from secondary market sales, these are also taxable income that must be reported.

The IRS has indicated that certain NFTs may be classified as collectibles, which are subject to a higher maximum capital gains rate of 28 percent rather than the standard 20 percent rate. Proper classification of your NFT transactions is important for accurate tax reporting.

Cost Basis Calculation Errors
Accurately calculating your cost basis in cryptocurrency is essential for determining your gain or loss on each transaction. However, many taxpayers make errors that either overstate their basis, resulting in underreported income, or understate their basis, resulting in overpaid taxes.

Common basis calculation problems include failing to include exchange fees and gas fees in your basis, using inconsistent cost basis methods across different transactions, losing records from defunct exchanges, and failing to track the specific lots of crypto being sold. The IRS allows several methods for determining which units of crypto you are selling, including FIFO (first in, first out), LIFO (last in, first out), and specific identification. Using the wrong method or applying methods inconsistently can result in substantial errors.

The Wash Sale Gray Area
Under current law, the wash sale rule that applies to stocks and securities does not technically apply to cryptocurrency. This means that if you sell crypto at a loss and repurchase it within 30 days, you can still claim the loss, unlike with stocks. However, this is an area where the law may change, and some taxpayers have pushed the boundaries by engaging in aggressive tax loss harvesting strategies that the IRS may challenge.

Additionally, if you are trading cryptocurrency through certain investment vehicles or if your crypto activity rises to the level of a securities dealer, different rules may apply. The safest approach is to document your positions thoroughly and be prepared to defend your treatment if questioned.

A CP2000 notice is not technically an audit, but it is a serious matter that requires prompt attention. These notices are generated automatically when the IRS identifies a discrepancy between information returns they have received and what you reported on your tax return. For cryptocurrency, this typically means an exchange reported your gross proceeds but you either did not report the income at all or reported it differently than the IRS expected.

The proposed tax assessment on a CP2000 notice often assumes your cost basis was zero, which dramatically overstates your actual gain. You have the right to respond with documentation showing your actual cost basis and the correct amount of tax owed. However, the response must be properly prepared and submitted within the deadline, or the IRS will assess the full proposed amount.

Working with an experienced tax professional at this stage is critical. A properly prepared CP2000 response can substantially reduce or even eliminate the proposed assessment. Failing to respond correctly can result in an unnecessary tax bill plus penalties and interest that continue to accrue.

If you have not reported cryptocurrency transactions from prior years, the question becomes how to come into compliance while minimizing penalties and avoiding potential criminal liability. There are several paths forward, and the right choice depends on your specific circumstances.

Filing amended returns is the most common approach for taxpayers who want to voluntarily correct past errors. You can generally amend returns for the past three years, and in some cases, you may need to go back further. Voluntary disclosure before the IRS contacts you can help reduce penalties and demonstrates good faith.

For taxpayers with significant unreported income or complex situations involving foreign exchanges, a formal voluntary disclosure may be appropriate. This provides more structured penalty protection but requires full disclosure and payment of back taxes.

The worst approach is to do nothing and hope the IRS does not notice. Given the IRS investment in cryptocurrency enforcement and the information reporting requirements now in place, the likelihood of detection is increasing each year. Taxpayers who are caught by the IRS before voluntarily coming forward face higher penalties and, in serious cases, potential criminal prosecution.

If the IRS selects you for a cryptocurrency audit, you will receive a letter identifying the tax years under examination and requesting specific documentation. Cryptocurrency audits typically require extensive records including exchange account statements, wallet addresses and transaction histories, records of purchases showing cost basis, documentation of any crypto received as income, and records of transfers between wallets and exchanges.

The IRS examiners working cryptocurrency cases have been specifically trained in blockchain analysis and digital assets. They can trace transactions across wallets and exchanges, identify unreported income, and reconstruct your crypto activity even if you did not keep good records.

Having professional representation during a cryptocurrency audit is essential. An experienced tax representative can communicate with the IRS on your behalf, ensure you do not provide more information than required, present your position in the most favorable light, and negotiate the best possible resolution if adjustments are proposed.

The penalties for cryptocurrency tax violations depend on the nature and severity of the non-compliance. Common penalties include accuracy-related penalties of 20 percent for negligence or substantial understatement of income, failure-to-file penalties of up to 25 percent of the unpaid tax, and failure-to-pay penalties that accrue monthly.

For serious cases involving willful evasion, civil fraud penalties of 75 percent may apply, and criminal penalties including fines up to $250,000 and imprisonment are possible. Additionally, if you held cryptocurrency on foreign exchanges and failed to file required FBAR or Form 8938 reports, you may face separate penalties for those violations.

Interest accrues on unpaid taxes from the original due date, regardless of whether penalties apply. For taxpayers with several years of unreported crypto gains, the combination of back taxes, penalties, and interest can quickly become overwhelming. This is why taking action sooner rather than later is so important.

California taxpayers face both federal and state tax obligations on their cryptocurrency gains. The California Franchise Tax Board has access to the same exchange information as the IRS and has been active in pursuing cryptocurrency tax enforcement.

California does not have a separate capital gains rate, so crypto gains are taxed as ordinary income at rates up to 13.3 percent in addition to federal taxes. This means California residents can face combined federal and state rates exceeding 50 percent on short-term cryptocurrency gains.

California residency questions can also complicate crypto tax situations. If you moved into or out of California during years when you realized crypto gains, determining which state has the right to tax those gains requires careful analysis. California is known for aggressively asserting residency and pursuing former residents who may have moved specifically to avoid state taxes on large gains.

Mike Habib, EA is a federally licensed Enrolled Agent authorized to represent taxpayers before the IRS and state taxing authorities including the California Franchise Tax Board. With over 20 years of experience in finance and taxation, including executive roles as Controller at Xerox Corporation and Director of Finance at AEG, Mike brings both technical expertise and practical business judgment to complex tax situations.

Unlike large national firms that charge $850 to $1,500 per hour and shuffle clients between junior staff, working with Mike means direct access to an experienced professional who personally handles your case from start to finish. Many cryptocurrency tax engagements are handled on a flat fee basis, providing cost certainty so you know exactly what to expect.

Services for cryptocurrency tax issues include responding to CP2000 notices with properly documented cost basis calculations, representing taxpayers in IRS and FTB cryptocurrency audits, preparing amended returns to correct prior year reporting, developing voluntary disclosure strategies for unreported crypto income, resolving back taxes through installment agreements or offers in compromise, and handling multi-state tax issues for clients who have moved or who traded on foreign exchanges.

Based in Whittier in Los Angeles County, Mike serves clients throughout California, nationwide, and Americans living overseas. Most cryptocurrency tax work can be handled remotely through secure document sharing and video consultations.

If you have unreported cryptocurrency transactions, received a notice from the IRS or California FTB, or are concerned about your crypto tax compliance, the most important step is to consult with an experienced tax professional before taking action. Do not ignore notices, do not attempt to respond without professional guidance, and do not assume the problem will go away on its own.

Start gathering your records now. Download your transaction history from all exchanges you have used, document any crypto received as income, and identify any wallets you have used for transactions. The more complete your records, the easier it will be to accurately calculate your tax liability and respond to IRS inquiries.

Contact Mike Habib, EA for a confidential consultation to discuss your situation. With competitive flat-fee pricing and direct access to an experienced professional, you can get the guidance you need to resolve your cryptocurrency tax issues and move forward with confidence.

Cryptocurrency tax problems rarely get better with time. The IRS continues to expand its enforcement capabilities, information reporting requirements are increasing, and penalties and interest continue to accrue on unpaid taxes. Taking action now puts you in control of the process rather than waiting for the IRS to contact you.

Mike Habib, EA provides experienced, personalized representation for cryptocurrency tax issues at a fraction of the cost of large national firms. Whether you need help responding to a notice, correcting past returns, or navigating an audit, Mike offers the expertise and direct service that complex crypto tax situations require.