IRS Audit Red Flags for Crypto Traders in California

The IRS is no longer taking a passive approach to cryptocurrency. With advanced data analytics and information from crypto exchanges, the agency is actively identifying taxpayers who may have underreported or failed to report their crypto gains.

For crypto traders in California, a state already known for its rigorous tax enforcement, the risk of an IRS crypto audit is higher than ever.

Understanding what triggers an audit can help you stay off the IRS’s radar. Here are the top red flags that could lead to a dreaded “love letter” from the IRS.

1. Failing to Answer the Virtual Currency Question

Since 2019, the front page of Form 1040 has included a question about virtual currency activity: “At any time during (this tax year), did you: (a) receive (as a reward, award, or payment for property or services); or (b) sell, exchange, or otherwise dispose of a digital asset (or a financial interest in a digital asset)?”

Checking “No” when you did, in fact, have transactions is a major red flag. This is the easiest thing for the IRS to verify, as they receive 1099 forms from major exchanges like Coinbase and Kraken. Answering untruthfully is akin to perjury and is a direct invitation for scrutiny.

2. Major Discrepancies Between Exchange 1099s and Your Return

If you receive a Form 1099-B, 1099-MISC, or 1099-K from a crypto exchange, you can be certain the IRS received a copy, too.

If the income reported on your tax return doesn’t align with the information on these forms, the IRS’s automated systems will flag the mismatch. For example, if a 1099-B shows $100,000 in proceeds but your Schedule D shows only $5,000 in gains, the IRS will want to know why.

This is a common issue for traders who don’t properly account for their cost basis.

3. Large and Frequent Transactions

While not a red flag in itself, high-volume trading activity naturally increases the complexity of your tax return and the potential for errors. The IRS may pay closer attention to returns with millions of dollars in transaction volume.

Furthermore, a large number of transactions makes it more likely that you or your tax software made a mistake, such as miscalculating the cost basis or misclassifying a transaction, which could trigger an audit.

4. Claiming All Crypto-to-Crypto Trades are Non-Taxable

This was a common misconception in the early days of crypto, but the IRS clarified its position years ago. Since 2018, trading one cryptocurrency for another (e.g., BTC for ETH) has been a taxable event.

You must recognize a capital gain or loss on the disposition of the first crypto. Filing a return that shows zero gains from crypto-to-crypto swaps is a clear indication that you are not following IRS guidance and could be selected for an IRS tax audit in California.

5. Using Crypto Mixers or Privacy Coins

While there are legitimate privacy reasons to use services like Tornado Cash or privacy coins like Monero, the IRS views them with suspicion. These tools can be used to obscure the flow of funds and are often associated with illicit activities and tax evasion.

If an IRS investigation uncovers the use of mixers, it will almost certainly lead to a deeper examination of your entire financial history.

How to Protect Yourself from a Crypto Audit

The best defense is a good offense. Here’s how to minimize your risk:

• Keep Meticulous Records: Document every single transaction. Use reputable crypto tax software to track your cost basis and calculate your gains and losses accurately.
• Report Everything: Don’t be tempted to omit transactions. The IRS’s reach is expanding, and it’s better to be transparent.
• Work with a Specialist: The complexities of DeFi, staking, and NFTs often require more than a standard CPA can handle. A California crypto tax attorney can ensure your return is accurate, compliant, and defensible in the event of an audit.

If you have received a notice from the IRS or are concerned about your crypto tax reporting, don’t wait. Contact the experts at Kugelman Law for a confidential consultation to understand your options and protect your assets.

Disclaimer: This article is for informational purposes only and is not intended as legal or tax advice. You should consult with a qualified professional for advice tailored to your individual circumstances.