Crypto tax problems often start with a simple accounting failure: You cannot prove your cost basis.
Cost basis drives gain or loss. When you cannot substantiate basis, the IRS may treat your basis as zero, which can effectively treat the full proceeds as taxable gain. The IRS can also broaden the audit, and, in the wrong fact pattern, frame the issue as deliberate concealment rather than poor recordkeeping. The same dynamic can trigger California exposure because California taxes capital gains as ordinary income under its personal income tax rates, so it does not apply a preferential capital gains rate and can pursue civil enforcement and criminal tax investigations through its own channels.
Cost basis gaps happen more often than taxpayers expect. They arise when taxpayers move digital assets between wallets and exchanges, trade token-for-token, use decentralized platforms, receive assets through staking, airdrops, or services, and then rely on incomplete exchange exports or third-party software that cannot connect to the full history. The IRS has
How digital asset basis works, and why gaps appear
The IRS treats digital assets as property for federal income tax purposes, so the general tax principles governing property dispositions apply to most crypto transactions. When you sell digital assets for U.S. dollars, exchange one digital asset for another, or otherwise dispose of a digital asset, you generally trigger a taxable event and must compute gain or loss using your adjusted basis and your amount realized. The IRS also expects you to account for transaction costs that affect gain calculations.
For example, the IRS explains that transaction costs can reduce the amount realized on a sale or disposition, and transaction fees can increase the basis on a purchase. In practice, cost basis gaps appear because digital assets do not behave like a single brokerage account with clean lot tracking. For example, you can buy cryptocurrency on one platform, transfer it to a self-custody wallet (a digital wallet where only you control the private keys), swap it via a decentralized protocol (a blockchain-based platform that allows peer-to-peer exchanges without intermediaries), bridge it to another chain (moving assets between different blockchain networks), and later sell it on another exchange. Each step can fracture your basis trail unless you keep contemporaneous records that connect specific units, dates, and transaction values.
You create basis problems when you report proceeds without accounting for holding periods (the length of time you own an asset before selling) and lot identification (assigning specific purchase records to each unit sold). The IRS permits "specific identification" of units in defined circumstances if you identify the units no later than the date and time of the transaction and maintain adequate records. If you fail to do so, the IRS's default rule is
How basis gaps can cause phantom taxable income
If you have lost wallets or trading records from an exchange at any point in time, this creates potentially problematic gaps in your crypto records. During an audit or criminal tax investigation, the IRS often will take the approach that when crypto without a provable trading history enters a wallet or exchange from an unidentified address, it will treat the fair market value of any basis gap coins as ordinary income to the taxpayer. The IRS has also been known to additionally assess self-employment tax on such activity.
The IRS also may consider a transfer out of a wallet as a capital tax event if you cannot prove the address it was sent to belongs to you or, alternatively, that the coin was transferred as a bona fide gift. The IRS ordinarily considers such crypto to have been sold to purchase goods or services resulting in a gain for the difference between the coins' basis and its fair market value upon transfer being reported on Schedule D via Form 8949 on the individual's tax return.
New broker reporting rules will surface basis problems
The IRS has moved digital assets into broker reporting. The Treasury and the IRS issued final digital asset broker reporting regulations under
You should also understand a key timing detail. For dispositions a broker effects in 2025, Form 1099-DA reporting generally focuses on gross proceeds and generally does not require basis reporting. Under the phased-in rules, basis reporting applies to certain covered digital asset transactions a broker effects on or after Jan. 1, 2026, subject to the covered-transaction rules. That structure can create a dangerous trap. Many taxpayers will receive proceeds without basis data, and taxpayers who cannot substantiate their basis will face a higher risk of an overstated gain assessment and a credibility problem in the audit.
Reporting changes affect how you report asset dispositions. You generally report digital asset dispositions on Form 8949 and Schedule D, including amounts reported on information returns such as Form 1099-DA, and you use Form 8949 to report any necessary adjustments, which flow to Schedule D.
The IRS requires taxpayers to answer the digital asset question on applicable returns, and it publishes guidance, including a Digital Assets Questionnaire, to help taxpayers answer accurately. An incorrect answer can increase risk if the IRS later substantiates transactions through information reporting or other records. A false answer increases risk if the IRS proves dispositions using broker reports or other records.
How basis gaps turn into audits, penalties and criminal tax investigation risk
Cost basis gaps drive audits because they allow easy adjustments and narratives. If the IRS sees proceeds but cannot confirm the basis, it may propose extra tax, assuming unreported gains. You then must substantiate your basis with records. If you can't, the dispute shifts from bookkeeping to an attempt to hide a taxable gain.
Civil tax penalties escalate financial exposure. The Internal Revenue Code imposes a 20% penalty for certain underpayments and a 75% civil fraud penalty on the portion of an underpayment attributable to fraud. The distinction often hinges on intent. A cost basis gap due to missing records may indicate negligence or a substantial understatement. If the gap coincides with fabricated documents, deliberate wallet obfuscation, false statements to examiners, or false answers to digital asset questions, it can support a finding of fraud.
California state can add parallel pressure
Criminal tax exposure hinges on willfulness and affirmative acts. Federal law criminalizes tax evasion, willful filing of false returns, and willful failure to file or supply required information when necessary. A cost basis problem can trigger these statutes if the government proves more than mere error, such as when a taxpayer intentionally omits disposals, inflates basis, hides proceeds to frustrate tracing, or provides false explanations to the IRS.
You should also treat "basis repair" carefully. "Basis repair" refers to correcting records of an asset's purchase price for tax purposes. IRS guidance and the final broker-reporting rules emphasize recordkeeping and lot identification, including when you transact across custodial platforms and self-custody wallets.
The IRS issued transition guidance addressing "unattached basis" and allowing a safe harbor to allocate unused basis for purposes of the broker reporting transition, with a January 1, 2025, transition date. Any careless amendment, unsupported reconstruction or inconsistent narrative can contribute to "
