Worried About a Crypto Tax Audit? Here’s How the IRS Will Track You—And How to Protect Yourself
Why are crypto tax audits scary?
Audits of crypto income evoke fear and terror because taxpayers don’t know what to expect—the average audit takes about 15 months. The audit process is intricate, often demanding detailed financial records and adherence to specific reporting requirements.
If you challenge the auditor’s assessment, an appeal to the U.S. Tax Court, which is often necessary, can take another two years to resolve. The fear of an audit’s results causes financial anxiety, marital strife, divorce, employment issues, and prolonged health effects from stress.
How far back can the IRS audit you?
The statutes of limitation provide some comfort. After the return is filed, the IRS has only three years to assess additional taxes. They get six years to assess if you underreport your income by 25%.
If they can assert the taxpayer intentionally falsified the tax return (fraud), there is no statute of limitation protection. With an increased focus on digital assets, it is expected the IRS will send many warning letters to notify taxpayers about potential discrepancies over the next few years.
Why do crypto traders have huge audit risks?
The IRS states that 75% of crypto traders do not report their crypto taxes. For many, this non-compliance might initially result in civil penalties due to negligence or unawareness of reporting requirements.
Civil penalties are typically monetary and do not involve jail time.
However, if the IRS detects intentional evasion or fraudulent actions, traders could face more severe criminal penalties, which include substantial fines and potential imprisonment. I’ve talked to thousands of taxpayers about their crypto tax reporting. It’s a familiar story.
Most crypto investors had little investing experience before buying cryptocurrencies. The first year, they don’t report their gains (called capital gains) because they didn’t know they had to or didn’t know how. They become vaguely aware of their tax obligations in the second year, but they become paralyzed because they didn’t report the prior year.
So, another year of non-reporting occurs. This logic continues each year. Soon, they realize they owe a mountain in taxes they could never pay. They never planned to be criminal tax evaders. Now, with the complicated reporting requirements and the looming presence of the audit examiner, they don’t know how to become compliant again safely.
How Does the IRS Discover Virtual Currency Transactions?
The IRS doesn’t need to guess anymore. They've built a multi-layered system to track crypto activity, both on and off-chain.
- 1099-DA is coming in 2026: Starting with the 2025 tax year, exchanges like Coinbase, Kraken, and Gemini will be required to issue Form 1099-DA to U.S. taxpayers. This new form captures sales, proceeds, and potentially cost basis—giving the IRS a standardized view into your trading activity.
Source: CryptoTaxAudit Blog – “The 1099-DA Is Coming in 2026”
- John Doe summons: The IRS uses the courts to compel exchanges to hand over customer data. This is how they got records from Coinbase, Kraken.
- Global data sharing via the J5 initiative: The IRS also obtains crypto transaction information by sharing data with other governments called the J5 initiative (US, UK, Australia, Canada, Netherlands).
- Blockchain forensics: Transferring crypto to or from a centralized exchange provides the IRS with a traceable blockchain address. From there, forensic tools can map your full wallet network—even if the rest of your trades happen in DeFi or via self-custody.
- Palantir AI surveillance: With a $99M contract, the IRS leverages AI tech from Palantir to analyze trading behavior, social media, and other digital breadcrumbs to detect underreporting or fraud.
What does this mean for the crypto trader?
If you are a crypto trader in the U.S., assume the IRS knows who you are and how large a trader you are. Assume that they have cross-checked against your tax return to see if taxable income is reported from your investments in crypto assets. But time is on the IRS’ side. The fact that they haven’t audited all non-compliant crypto owners is more about limited resources than lack of knowledge.
What are my chances of an audit?
First, given the discussion above, what has been your total positive income in past years?
The 2020 audit rates (percent audited) are less than a tenth of the historic audit rates (from 2010) for total positive income greater than $500,000. The IRS Commissioner implied audit rates for these income brackets will far exceed the historic audit rates. This would mean at least ten times greater audit rates for crypto investors making many trades.
| Size of Total Positive Income | 2020 Indiv. Rtns | Percent Audited | Historic Audit Rates |
|---|---|---|---|
| No total positive income | 3,631,912 | 0.3% | 25.5% |
| $1 under $25,000 | 49,787,775 | 0.4% | 1.0% |
| $25,000 under $50,000 | 39,516,857 | 0.2% | 0.6% |
| $50,000 under $75,000 | 23,041,847 | 0.1% | 0.7% |
| $75,000 under $100,000 | 14,726,736 | 0.1% | 0.7% |
| $100,000 under $200,000 | 23,403,399 | 0.1% | 0.8% |
| $200,000 under $500,000 | 8,165,629 | 0.2% | 2.3% |
| $500,000 under $1,000,000 | 1,385,407 | 0.4% | 3.6% |
| $1,000,000 under $5,000,000 | 622,329 | 0.4% | 8.2% |
| $5,000,000 under $10,000,000 | 46,254 | 0.7% | 13.5% |
| $10,000,000 or more | — | 2.0% | 25.5% |
Smaller traders are less likely to be audited than larger traders because auditors are inclined to spend their time on larger trades.
Wait! Did the IRS say they would only increase audit rates on the rich?
The IRS has publicly claimed that it won’t increase audit rates on those earning under $400,000.
This is very deceiving.
When the average person hears “income,” they think about net or gross income. However, the IRS is referring to total positive income, which is very different. Total positive income means the total amount of proceeds before deducting any costs or losses.
For crypto traders, this means the IRS looks at the value of what you sold, not your actual profit. So even if you lost money, a high-volume trading year can still put you in a high-risk audit category.
Will the IRS use more criminal enforcement?
Expect the IRS to use criminal enforcement more to pursue non-compliant crypto traders. Willfully failing to report significant crypto income can be handled as criminal fraud, and failing to file at all can be treated as illegal tax evasion. Both crimes are considered felonies. In both situations, the IRS lawyers only need to prove to the courts that over $10,000 of income was intentionally not reported to evade taxes.
Criminal enforcement is easier and quicker for the IRS to win than traditional audits.
Traditional audits, including appeals, can take 2–4 years to conclude, consuming many man-hours of labor. Audits of crypto raise complexities about the correct capital gain calculation, which can be aggressively contested in court.
Whereas with criminal enforcement, once a Department of Justice attorney delivers an indictment to a trader, all that is left to do is agree on the plea bargain. The taxpayer must still file past taxes plus an up to $250,000 fine and prison time.
Criminal investigation takes fewer resources and is more profitable with higher odds of winning.
Is there a better way for traders to protect themselves?
Wouldn’t it be powerful if you could know in advance if the IRS thinks you were under-reporting income or had flagged one of your returns for a future audit?
Investors need a more proactive monitoring strategy and a strategy in case the IRS contacts them.
How do you get in compliance using a transition strategy?
But for many, paying taxes on past gains (which may have evaporated during a bear market) is more than they can afford. They want to get back to compliance but don’t know how.
Here is an approach many have used to transition to compliance under the radar, so to speak.
Step 1: Proactive IRS monitoring.
Continual monitoring of your IRS accounts is critical to protecting yourself. Monitoring your IRS accounts allows you to detect under-reporting of income, a common cause of audits. Also, the monitoring can see when a tax year is flagged for an audit one to six months before the formal start of an audit, giving you time to correct issues, avoiding accuracy penalties or even the entire audit. These two indicators alone can keep you from getting in the crosshairs of an IRS audit.
This foundational protection is available through our Tax Shield service. It’s a low-cost, entry-level monthly membership that monitors your IRS file and alerts you to audit risk. All tax years are covered. Spouses are included for free. You can cancel anytime.
🛑 Just keep in mind: this is monitoring only. It’s your first step toward compliance, but not full legal defense. If you want audit defense or help getting back on track, our team can upgrade you to full protection plan.
Step 2: File the latest year’s return and pay the taxes.
Start by accurately preparing a return reporting all your crypto income for the latest year’s return. This return will be compliant. The prior year's returns will age beyond the statute of limitations by continuing to file honest returns in subsequent years.
You should recalculate your crypto gains for the prior six years so that the gains reported in the latest year’s return will be consistent with prior returns if you file them in the future.
A common concern taxpayers have with this strategy is thinking that if they file this year, the IRS will wonder why they didn’t report crypto gains in prior years. The electronic filing system doesn’t ask these questions. The IRS accepts returns as filed. Don’t let this concern paralyze you.
Step 3: Be prepared to file a past return quickly.
Even if you're not ready to file past years yet, be prepared to act quickly. If our monitoring service flags an IRS audit or transcript change, you may need to file or amend a return fast. Having prior years ready—or at least reviewed—puts you in a stronger position.
Step 4: Have an IRS audit strategy.
The start of an audit is terrifying. You’re suddenly scrambling—should you hire a lawyer? A CPA? A crypto tax expert? Most professionals understate how long an audit will take or how expensive it will be to fight back.
Defending a crypto audit the right way means recalculating thousands of transactions, challenging the IRS’s gain calculations, and sometimes petitioning the Tax Court. This process can drag out over two to four years, and it’s not uncommon for total defense costs to exceed $150,000.
Tax Shield gives you early warning—but it’s not full protection. If your case is complex or you're facing serious IRS action, you’ll need a Full or Represent Membership. That’s what covers expert help, hands-on audit defense, and all your representation costs.
💡 We’ve laid out exactly what each plan includes on our pricing page—take a minute to review your options before the IRS makes the first move.
Step 5: Backup all your transaction records.
The tax code places the burden of recordkeeping on you. If an exchange shuts down or deletes your history, the IRS won’t accept “I lost my data” as an excuse. So back up your full transaction history from all exchanges. Store a secure copy and keep a list of all your wallet addresses.
🔐 Final Thought – Don’t Just File. Defend.
If you're serious about protecting your crypto gains, filing alone isn't enough. The IRS has better data, more funding, and stronger tools than ever—including AI-driven analysis, blockchain tracing, and international cooperation.
Tax Shield is your starting point—it monitors your IRS transcript and alerts you early. But if your case calls for action, monitoring isn’t enough.
Full protection means having our team defend you when the IRS shows up—and that’s only included with a Full or Represent Membership.
👉 Visit CryptoTaxAudit.com to activate your Tax Shield today—and take the first step toward true crypto tax security.
