Some may not realize the capital gains or losses in their crypto trade are taxable, tax experts say.

Hello! Welcome back to Distributed Ledger, our weekly crypto newsletter that reaches your inbox every Thursday. I'm Frances Yue, crypto reporter at MarketWatch. It is tax season in the U.S., and I'll walk you through the important things to keep in mind when reporting crypto trading on your tax returns.

Meanwhile, if you'd like to talk about what taxes are going to mean for your investments, DM me on Twitter at @FrancesYue_.

Subscribe here to the DL newsletter, if you haven't done so.

Crypto in a snap

Bitcoin have been consolidating in the range of $35,500 and $39,500 during the past seven days. The crypto logged a 0.9% gain during the period. Ether gained 9.8% over the past seven trading sessions, trading at around $2,629.

Meme token Dogecoin lost 3% over the seven-session stretch, recently trading at around $0.137. Another dog-themed crypto Shiba Inu recorded a 1.7% loss, recently trading at around $0.00002.

Crypto Metrics

Biggest Gainers  Price    % 7-day return 
Maker            $2313.7  35.3% 
Immutable X      $3.92    33% 
Tezos            $3.92    32.5% 
Quant            $128.85  31.4% 
LooksRare        $4.85    27.5% 
                          Source: CoinGecko as of Feb. 3 
Biggest Decliners  Price    % 7-day return 
Loopring           $0.839   -22.3% 
Terra              $49.83   -15.4% 
Fantom             $1.94    -14% 
ECOMI              $0.0067  -13.4% 
Cosmos             $28.47   -12.1% 
                            Source: CoinGecko as of Feb. 3 

Crypto tax can be complicated

Reporting crypto on your tax returns can be a headache.

Cryptocurrencies are treated as property for federal income tax purposes in the United States, and investors are required to pay a certain percentage of tax on capital gains incurred when they dispose of their crypto.

Unlike in the stock market, where investors could buy, sell and trade different stocks through one brokerage, it is common for crypto investors to trade on different exchanges and use multiple wallets.

While stock traders get an all-in-one Form 1099-B from their broker, in crypto, "it's the users' responsibility to connect all the exchanges and wallets into just one place, to record and figure out the taxes for that year," Shehan Chandrasekera, head of tax at crypto tax calculator CoinTracker, told MarketWatch in an interview.

CoinTracker and other platforms such as TokenTax, Koinly and TaxBit, provide tools for investors to track their crypto portfolio on different exchanges and DeFi protocols.

It is difficult for crypto exchanges to gather such information, Chandrasekera noted. "Let's say that I'm transferring one bitcoin from my Coinbase account to Uniswap. Uniswap doesn't know how much I paid for that coin, because the purchase never happened inside Uniswap. So they cannot do the tax information without knowing the cost basis because exchanges don't talk to each other," Chandrasekera said.

Coinbase (COIN) is a Nasdaq-listed crypto exchange, while Uniswap is a decentralized crypto exchange.

It amplifies the pain that crypto traders often buy one cryptocurrency using another cryptocurrency, which creates taxable events. "In the stock world it never happens. You don't buy Google stocks using the Apple stocks," Chandrasekera said.

Ultimately, the responsibility lies with taxpayers to keep track of their cost basis, fair market value and USD gain or loss whenever they dispose of a crypto asset. "We all can only think about tax during tax season. But the reality is that taxable events are happening all year long, " said Ben Borodach, co-founder of tax software April.

Is crypto mining income taxable?

The answer is yes, according to the IRS guidelines.

When one mines cryptocurrencies successfully, they must report the fair market value of the mined tokens as of the date of receipt as their gross income, the IRS said.

What about NFTs?

Trading NFTs could also create taxable events. "If you think about an investor who buys an NFT, they probably had to take their dollars to buy another crypto and then use that crypto to buy the NFT. Well, they just had a potential capital gain or capital loss and they may not have realized that," according to Borodach.

Meanwhile, when a creator sells an NFT on marketplaces such as OpenSea or LooksRare, their profits are subject to income taxes.

The IRS knows

"A lot of people think that crypto is completely invisible from the IRS and the regulators, because it's anonymous. That's not true," CoinTracker's Chandrasekera said.

The IRS could detect crypto transactions in different ways, even when investors do not withdraw cryptocurrencies from their wallet and convert them into fiat currencies.

To start with, some crypto exchanges send Form 1099 to IRS, alerting the agency that a taxpayer has been trading cryptocurrency. Thus, the taxpayer is likely to be expected to report crypto on their tax returns.

Meanwhile, the IRS first added a question about virtual currencies in Form 1040 in 2019. The 2021 version of IRS Form 1040 asks, "at any time during 2021, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?" MarketWatch's tax columnist Bill Bischoff wrote about how to answer that question here.

When it comes to criminal activities, the IRS may also use blockchain analytics tools, tying pseudonymous wallets to actual people involved in illicit activities, Chandrasekera noted.

Read more: The party's over for some AMC and GameStop investors, but luckier meme-stock winners are bracing for a massive tax bill