Cryptocurrency Part I: What It Is & Why It’s Important
It’s probably safe to say that, no matter who you are, cryptocurrency has found its way into a few of your recent conversations. When you consider that it would have cost you around $100 to purchase 100 Bitcoin in 2011, and that the investment would be worth nearly $4 million today, the idea is intriguing, to say the least. But, these investments occur in a market sector that’s rife with volatility, and the same volatility applies to cryptocurrencies received as payment or in company transactions. So investors, business owners, and professional advisors alike should understand the way cryptocurrency behaves as an asset, a reporting obligation, and a tax liability, to adequately balance the potential risks with the potential rewards.
This article will be the first in a series that explores the many facets and relevancies of cryptocurrency. In Part I, I’ll cover the basics of cryptocurrency, why it matters, and some of the related tax implications. Stay tuned for future additions, which will cover the effects of using cryptocurrency in company transactions, data mining, and more.
What is cryptocurrency?
Cryptocurrency is a digital currency that uses cryptography, a practice to ensure only the sender and intended recipient of a message may view its contents, to provide transaction verification and record maintenance across a decentralized system. Cryptocurrency is not regulated by a centralized bank or monetary authority. Instead, it is built on blockchain technology, a digital ledger of transactions on a decentralized platform housed on countless servers worldwide.
Because of the way it’s set up, it allows for transactions to be recorded and assets to be tracked in a manner that is virtually fraud-proof. Cryptocurrency is digitally confirmed by a process called “mining,” which uses a complex digital code set up on the network to check all the information entering the blockchain mathematically and confirm and verify all new entries and changes to the ledger. (We will discuss this topic more in depth later in this series.)
Where did cryptocurrency get its start?
While alternative investments like cryptocurrency have become topics of increasing interest over the last few years, the practice isn’t really that new. Back in 1996, E-gold was introduced as an electronic form of gold currency backed one-to-one by gold reserves held in private agency vaults. Digital gold is undoubtedly less susceptible to market volatility than cryptocurrency, but digital gold set the stage for other digital investments like cryptocurrency.
Bitcoin – In 2009, Bitcoin was the first cryptocurrency to hit the scene. As such, all other forms of cryptocurrency are referred to as “Altcoins.” Today, Bitcoin remains the leader in market capitalization, holds the largest user base, and is the most-traded form of cryptocurrency. To date, the price of one Bitcoin was at its highest at $68,000 in November of 2021. As of the early morning of January 24, 2022, the price of one Bitcoin was $33,077.80.
Ethereum – In 2013, Ethereum introduced Ether, a decentralized finance token (DeFi token) with smart contract functionality. Ethereum provides built-in software programming languages, which can be used to write contracts covering the transfer and mining of Ether. To date, the price of Ether reached its highest at $4,644.43 in November of 2021. As of the early morning of January 24, 2022, the price of Ether was $2,215.88.
Stablecoins – Stablecoins, which came into the mix in 2014, are tied to fixed reserve assets. This type of cryptocurrency provides stability in place of volatility, as it is not meant to fluctuate. Fiat-backed stablecoins are tied to fiat currencies, such as the US Dollar. Generally, this is a one-to-one relationship, so in this case, one stablecoin could be equal to $1USD. Cryptocurrency-backed stablecoins, such as Wrapped Bitcoin, are backed by other cryptocurrencies. Commodity-backed stablecoins are backed by hard assets, such as gold or other precious metals. And seigniorage-style stablecoins are non-collateralized but are baked instead by algorithms, processes, or working mechanisms.
Why is cryptocurrency important?
Cryptocurrency has proven its ability to disrupt the global financial system. Today, nearly 10,000 cryptocurrencies exist and are traded across their own native blockchain platforms. And cryptocurrency isn’t going anywhere. Because these transactions are fast, secure, and worldwide, trading in cryptocurrency breaks down barriers and opens up opportunities.
More and more retailers, especially those with primarily internet-based sales, have started accepting Bitcoin payments. Many large banks are also rethinking the way they work with cryptocurrency. For example, JPMorgan used Ethereum to build Quorum, their enterprise blockchain platform. In 2017, they partnered with Zerocoin Electric Coin Company (ZECC) to incorporate the same privacy technology used for Zcash into their platform. Bank of America already offers a global payments platform and, in October 2021, announced the launch of a cryptocurrency research division.
What are some of the tax implications to consider?
For IRS purposes, cryptocurrency is treated as property. Generally, capital gains or losses are recognized, and investors are required to disclose cryptocurrency assets on Form 1040.
Since cryptocurrency is not considered cash, individuals cannot make cryptocurrency contributions to an Individual Retirement Account (IRA). However, IRAs can make investments, so an IRA may acquire cryptocurrency by purchase. If you have a self-directed IRA, you may include cryptocurrency in your retirement portfolio if the investments are made through an LLC that’s 100% owned by the IRA. Because the retirement account will own the assets, gains will be tax-deferred.
Currently, a “wash sale” loophole exists, which allows certain taxpayers to offset profits with losses. For example, suppose you purchase Bitcoin at $40,000, and the value drops to $30,000. In this case, you may be able to sell, use the $10,000 loss to offset other gains, and repurchase the asset afterward. However, updating the wash sale rules is already on the agenda for Congress, so the loophole will likely close in the near future.
Staking is a process investors sometimes use as part of their tax strategy to earn passive income by locking up or delegating tokens in wallets for a specific period to earn rewards. However, staking does produce interest-like income.
Historically, digital wallets have been poor accounting mechanisms for year-end reporting. It’s up to you to calculate annual profits or losses across all exchanges and disclose taxable transactions. Companies like TaxBit offer services to help investors aggregate their cryptocurrency-related tax information for year-end reporting purposes.
Beginning on January 1, 2023, brokers, including brokerage houses, cryptocurrency miners, and wallet developers, will also be required to report cryptocurrency transactions and transfers of digital assets to non-brokers on Form 1099-B.
Contact LGA
LGA’s Individual & Family, Business, & International Tax Teams are here to help. If you’d like to learn more about cryptocurrency or have questions about the tax implications of your digital assets, contact me today. And don’t forget to stay tuned for future parts of this cryptocurrency series.
by Derek Silveira, CPA, MST
Derek joined LGA with the merger of Vasil Dowd Silveira, CPA’s in 2019, where he was a partner. He brings a personal and understandable approach to complex and far-reaching tax situations. His experience includes working with individuals, multi-state companies and in-bound foreign entities, and on business taxation issues for flow-through entities and their owners.