The 7 Types of Crypto Tax Nightmares

Thabo Abbate, a CPA who does accounting for cryptocurrencies, has seen plenty of tax nightmares. But this one still gets him.

His client was a yoga instructor. She lived in New York and made less than $50,000 per year, and in 2016, she started trading crypto. On Twitter, she found some “crypto trading influencers” and used their advice to make trades. At first she only invested a little bit of money. But the trades worked. “It was 2016, and if you just threw a dart at a coin you’d make money back then,” Abbate says now.

This piece is part of CoinDesk’s Tax Week

The yoga instructor, emboldened, decided to place bigger bets. Why not make some real money? So she started to trade on margin. She mostly copied the trades of some crypto trading influencers, and, once again, they started to work. She took around $1,000 of capital and turned it into $100,000. She had done it.

“Then the tax bill comes due,” said Abbate. The yoga instructor would have been fine if she sold her $100,000 portfolio and tucked a portion away for taxes. But of course she didn’t do that – many crypto traders don’t. Instead, she kept trading on margin. And eventually she lost all of her crypto.

Now she had to pay taxes on this $100,000 capital gain … but with nothing left in the bank. “The tax bill was basically more than she could earn in a year,” said Abbate.

Welcome to the horror stories of Crypto Tax Nightmares. They usually look something like this: You mess around with crypto, you make some money, you don’t think about taxes, then the market drops and BOOM suddenly you’re underwater.

Crypto Reddit is littered with these kinds of sad stories, such as the office assistant with a salary of $47,000 who racked up a $50,000 tax bill – that he couldn’t pay – concluding that “I feel like I might have accidentally ruined my life.”

Or the crypto trader who realized, in horror, “My country will get marginally richer because I f**ked up my tax planning,” and that “after they'll take everything I have, I'll still be in debt for the rest of my life.”

From conversations with tax experts, these nightmares come in seven forms:

1. The 'Buy in a Bull Market, Sell in a Bear Market' Nightmare

The biggie. They usually look like this: “I found Bitcoin in 2017. It was so exciting. I started trading the altcoins trying to make more bitcoin,” said Brady Swenson, the vice president of education and marketing at Swan Bitcoin, a service that offers automated bitcoin buying plans. “I made hundreds, maybe thousands, of trades,” he noted.

Swenson had never traded stocks before. He had never traded forex. He had never traded anything, and he had no idea there were tax implications. He never set anything aside. And in the meantime, the price of bitcoin cratered. So when tax season rolled around, “I had to sell over half my bitcoin just to pay the bill.”

Swenson is in fine company. “That’s definitely the biggest ‘Oh S**t Moment,” said David Kemmerer, CEO of CryptoTrader.Tax, a tax software startup. He saw this dynamic in both 2018 and now in 2022. “We’ve had it twice now,” said Kemmerer. “A huge bull market leading up to the end of the year,” and then a bear market when people need to liquidate to cover their taxes.

Or take the plight of a 31-year-old real estate agent in Chicago: “I dabbled in trading altcoins back in 2017,” he said. This “dabbling” made him around $650,000 in profits. Like Swenson, he had no idea he had to pay taxes on these trades, and when the tax man came, his crypto holdings plunged by 50%. “I was seriously screwed.” He owed $120,000 in taxes, and to pony up the money he had to liquidate his bitcoin … at the very bottom of the market. “Not only did it hurt me financially, but it also was a pain in the ass getting all my trading information and manually recording the trades one by one.”

Yet another example of this sad story: “Kevin Cage,” who worked in cybersecurity, thought he had a good 2017 trading crypto. His once-modest account soon swelled to several hundred thousand dollars (even though it was mostly “just pure luck and gambling”) … and you can see where this is headed. The market crashed, the tax bill arrived, and he had to liquidate his holdings to pay the $100,000 tab. “It made me sick to my stomach,” said Cage.

He lost sleep. He cut back on restaurants and scrapped plans for vacations. “It’s the worst feeling in the world,” he said. “People think you made a lot of money in crypto, and you talked about the wins, but at the end of the year you wished you took profits.” (This one has a happier ending. Cage bounced back, is a crypto millionaire living in Puerto Rico, and 130,000 people subscribe to his trading videos.)

Read More: US Crypto Tax Guide 2022

2. The 'Magic Crypto Money!' Nightmare

Many people think that once you’ve swapped your fiat for bitcoin or Ethereum, at that point, it’s in the realm of “Magic Crypto Money” and then, for days or weeks or even years, nothing is taxed until it’s converted back to fiat. Nope.

“I wish it worked that way,” said Kemmerer, but he sees clients regularly get hosed because they misunderstood how it works. “This one guy had acquired over 100 ethereum early on, in 2015, back when it was still cheap,” he said. Then, in 2021, he sold some of his Ethereum to buy non-fungible tokens (NFTs), thinking it was all in Magic Crypto Money Land. “He racked up over a $100,000 tax bill. It was a shock.”

3. The 'Transaction Hell' Nightmare

Another common nightmare: Making a flurry of trades across a range of platforms – Coinbase, Binance, FTX, Kucoin, Huobi and on and on – and not keeping records of your transactions. Each trade is a taxable event.

In 2017, Michelle O'Connor used a bot algorithm to automatically make trades while at Uphold (a trading platform). Not 10 trades or 100 trades. “I had like 20,000 or 30,000 trades,” she said, laughing now. Oops!

(O'Connor solved the nightmare by becoming TaxBit’s first customer; she was so impressed with the tax software startup that she later joined the team as the vice president of marketing.)

Read More: You May Owe Crypto Taxes on These Surprising Things in 2022

4. The 'Fleeting Wealth' Nightmare

In 2017, Shehan Chandrasekera, the head of tax at Coin Tracker, once worked with a limo driver who traded crypto as a side hustle. The driver made $150,000 in profit. Not too shabby. Maybe he could go from driving a limo to owning a Lambo?

Concerned, Chandrasekera asked the limo driver, “Hey, do you have the cash to pay your taxes?”

The driver was stunned. He hadn’t thought about taxes. And by the time his tax bill was due – in an all-too familiar story – the price had fallen and he sold at a loss. “He had never seen those kinds of gains in his life,” said Chandrasekera, and the driver had to set up a payment plan with the IRS. “There are so many stories like this,” said Chandrasekera. “Whenever the market goes up, that’s when all the people rush into the market. People got into bitcoin around $69,000, and now they’re underwater.”

5. The 'Passive Income' Nightmare

In 2017, all holders of bitcoin were air-dropped sums of bitcoin cash. One of Kemmerer’s clients owned a ton of bitcoin – a whale – and he was air-dropped $2 million worth of bitcoin cash. “He didn’t realize that the IRS treats a hard fork as a taxable event,” said Kemmerer, and he was later slapped with a surprise tax bill. (That said, it’s hard to shed too many tears for someone who receives $2 million literally out of thin air.)

But a more relatable nightmare: “Let’s say you’re generating yield, or providing liquidity,” said Kemmerer, such as receiving interest from the Compound token. “Every time you’re getting those rewards, that’s taxable income.”

Read More: Your Staking Rewards Are Still Taxable

6. The 'Oh S**t, You Pay Taxes QUARTERLY?!' Nightmare

“A lot of people think you only pay taxes at the end of the year. That’s not the case,” said Chandrasekera. As every freelancer knows, you’re expected to pay quarterly taxes if they’re not being withheld from your paycheck. But that’s also true if you’re buying and selling NFTs, said Chandrasekera. “If you’re just selling NFTs on OpenSea you have to do that, or you’re going to get penalized.”

7. The Future Nightmare

Finally, the most important nightmare is the one that you don’t know about yet. Many of the horror stories that TaxBit’s O'Connor heard from the 2017 tax year weren’t felt by her clients until 2019 or even 2020. “What people don’t realize is that the IRS is on a two-to-three year lag,” she said. “Just because you didn’t hear something doesn’t mean you’re not going to.”

So if you have a sinking feeling in your stomach that you flubbed your crypto taxes but maybe it’s OK, because the IRS didn’t notice?

You can breathe easy … in a decade.

Further reading from CoinDesk's Tax Week

US Crypto Tax Year 2022: Inflation-Based Changes to Know

To offset the impact of rising inflation, the IRS has revised a number of tax provisions to let people keep more of their money in their wallets for the 2022 tax year.

UK Crypto Tax Guide 2022

U.K. citizens that invested or dealt with crypto over the last year may be required to pay taxes on their trades. Here's what you need to know.

Canada Crypto Tax Guide 2022

Like many jurisdictions, crypto assets are treated as "property" in Canada, meaning investors will owe taxes to the Canadian Revenue Agency (CRA) in certain situations.