Few pieces of mail produce the same drop in the stomach as a letter from the IRS that mentions your cryptocurrency. It is worth saying at the outset that an audit is not a verdict. The outcome usually turns less on what you did three years ago than on how you respond now—whether the record gets reconstructed carefully, whether positions are framed before assumptions harden, and whether the characterization of each transaction is correct. This is what a cryptocurrency audit looks like, and what preparing for one actually involves.
Why Crypto Audits Are Rising
The IRS has treated cryptocurrency as property since Notice 2014-21, which means most dispositions are taxable events: selling for dollars, swapping one token for another, and using crypto to buy goods or services all count. For years, enforcement lagged the rules because the IRS lacked information. That gap is closing fast.
Three developments drive the increase. First, the digital-asset question on the front page of Form 1040 forces every taxpayer to answer, under penalty of perjury, whether they transacted in digital assets—turning silence into a defensible audit trigger. Second, Form 1099-DA: for transactions on or after January 1, 2025, custodial brokers report gross proceeds to the IRS, and for assets acquired and held with the same broker on or after January 1, 2026, they begin reporting cost basis as well. Third, the IRS has used John Doe summonses against major exchanges and contracts with blockchain-analytics firms to connect wallet activity to taxpayers. The practical result is more mismatches surfaced automatically, and more examinations opened from them.
What Triggers an Examination
Most crypto audits start from a mismatch rather than a hunch. A 1099 that does not reconcile with the return, a digital-asset box answered "no" against exchange records that say otherwise, large or frequent disposals, prior years with no reporting at all, or chain analysis linking a wallet to a taxpayer—any of these can open the file. The new 1099-DA regime will only sharpen this, because the agency now receives a stream of third-party data to compare against what taxpayers report.
The Real Fight: Basis and Characterization
Once an examination opens, two questions usually decide the outcome. The first is basis—what you paid for the asset you disposed of. Many taxpayers cannot fully document coins acquired years ago across several exchanges and wallets, some of which no longer exist. Where adequate identification is missing, the default is generally FIFO, which in a long-held, appreciated position can produce a far larger gain than the taxpayer expected. Reconstructing that history credibly, account by account, is often the whole ballgame.
The second is characterization. A sale, a crypto-to-crypto swap, staking rewards, an airdrop, and a hard fork are not taxed the same way, and treating them uniformly invites adjustments. Some areas remain genuinely unsettled—the timing of staking income, for instance, was litigated in Jarrett v. United States and is still debated—which means a well-supported position, rather than silence, is what protects against penalties.
How the Examination Actually Unfolds
It helps to know the shape of the process, because each stage is an opportunity to control the outcome. An examination usually opens with a notice and an information document request—a list of records the examiner wants. What you produce, and how it is framed, sets the terms of the discussion. The examiner then proposes adjustments. If you disagree, you are not stuck with the examiner's view: a "30-day letter" gives you the right to take the matter to the IRS Independent Office of Appeals, which exists precisely to resolve disputes without litigation and weighs the "hazards" of the government's position. If Appeals does not resolve it, a statutory notice of deficiency—the "90-day letter"—lets you petition the U.S. Tax Court before paying.
Penalties are their own battleground. The accuracy-related penalty under section 6662 adds 20% to an underpayment, and the civil fraud penalty under section 6663 reaches 75%. Both can often be avoided or reduced with a reasonable-cause showing or a properly supported position, which is one more reason the characterization decisions described above matter long before any penalty is on the table.
How to Prepare
The instinct to respond quickly and personally is usually the wrong one. Early, unguided statements to an examiner can lock in assumptions that are hard to dislodge later. Better to gather records methodically—exchange histories, wallet addresses, and any contemporaneous evidence of cost—and to reconstruct the full picture before conceding anything. Each transaction should be characterized correctly, and where the law is unsettled, the position should be stated and supported rather than left to the examiner's default assumptions.
Why an Attorney, Not Only a CPA
A CPA computes; an attorney advocates—and the difference matters in a contested audit. Counsel can assert legal positions, manage penalty exposure, evaluate whether a voluntary disclosure or qualified amended return is appropriate, and, importantly, communications with an attorney carry privilege that a return preparer's generally do not. As a cryptocurrency tax attorney with an LL.M. in taxation and admission to the U.S. Tax Court, my job is to control the record, frame the position early, and resolve the matter on the best defensible footing—not the examiner's worst-case one.
If you've received an IRS notice that references crypto, the clock is already running. Get in touch and I'll help you understand your exposure and the right next move.