When you file a tax return, you trigger the statute of limitations. In simple terms: the audit clock. The statute of limitations controls the time frame during which the IRS has the legal authority to audit your tax return.
What Is The Statute Of Limitations?
The statute of limitations is the time frame that the IRS has to examine your tax profile and assess additional taxes. The less time you legally offer the IRS to examine your tax return, the less likely the IRS is to find errors and assess additional taxes. You can use the Statute of Limitations to your advantage by understanding three rules: Three Year Rule, Six Year Rule and Forever Rule.
Three Year Rule
By default, the IRS has three years from the original tax filing deadline (normally April 15th, though extended to July 15 in 2020 due to COVID-19) or the date you file your taxes, whichever is later, to assess additional taxes on your return. For example, if you were to file your cryptocurrency transactions on your tax return on April 1, 2020, the IRS has until July 15, 2023 (three years from July 15, 2020) to audit your return. After this date, the IRS cannot generally examine your return and assess taxes unless you fall into the “Six Year Rule” or the “Forever Rule.”
Side note: As a result of COVID-19, the IRS extended tax filing deadline to July 15, 2020 for 2019 tax year. If you filed your tax return in the beginning of the tax season around February, your three year statute of limitations would not start until July 15, 2020. This indirectly gives additional time for the IRS to examine your return.
Six Year Rule
The “Six Year Rule” extends the IRS power to audit your return up to six years from the filing. This happens only if you understate income reported in the return by more than 25%. Let’s say you had $100,000 worth of crypto capital gains in 2019 but you only reported $70,000 in 2019. You filed your 2019 tax return on July 1, 2020. In this case, the IRS has the power to audit your tax return and assess taxes on missing gains up until July 15, 2026.
If you do not file a tax return or commit fraud (filing a false return or willfully attempting to evade taxes), the IRS can audit your return indefinitely. This, in addition to the fact that on-chain cryptocurrency transactions are recorded on an indelible public ledger forever, is the reason why not filing a return is the biggest mistake a crypto user can make. If you do not file a return, you do not start the statute of limitations, and you may be liable for back taxes forever.
Key takeaways to remember when filing your cryptocurrency tax return:
- If you are getting a refund, file as soon as possible to get cash in hand faster
- If you are not getting a refund, file your taxes as close as possible to the original tax deadline to limit the audit clock for three years and give no additional time to the IRS
- Even if you are struggling to precisely calculate your cryptocurrency gains, make sure not to underestimate your gains by more than 25%. Crypto tax software can help here.
- Most importantly, file something on your return to start the audit clock
Disclaimer: this post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.