It seems like you can’t go a single day without hearing something about bitcoin, litecoin, Ethereum, Bitcoin Cash, and, at last count, at least 1,500 other known digital currencies (or “cryptocurrencies”). In light of Bitcoin’s recent meteoric rise to $16,000 per coin and the hysteria surrounding that rise (and fall, to about $6,500 per coin currently), here are five items you might want to know about cryptocurrencies before you jump in.
1. Description: You say bitcoin, I say blockchain; what’s the difference? Blockchain is the technology (created in 2009) behind bitcoin and all cryptocurrencies. Cryptocurrencies only exist in the digital universe as a string of bits and bytes—there is no physical currency and no central authority supporting it. There is a limited supply of each type of cryptocurrency, set by the program that created it. The value of any cryptocurrency (or fraction of a cryptocurrency) is what someone is willing to pay for it.
2. How It Works: Cryptocurrency works on blockchain. Simply put, you request a transaction (for example, buy a bitcoin), and the request is broadcast to many computers which validate the transaction using sophisticated algorithms unique to each type of cryptocurrency. Once the transaction is verified, it is added to the blockchain, and the parties to the transaction can see it to confirm it happened. The transaction can take minutes to confirm—it depends on how many computers are involved in confirming it. Once confirmed and added to the blockchain, the transaction is designed to be permanent and unalterable.
3. Security: Your transaction is added to a continually growing set of data blocks in a way that can never be altered. The methods used are beyond the scope of this blog post, but your transaction block is digitally linked to all the blocks after it, so trying to change just one bit of your transaction is instantly visible, as every other block relies on your block to remain unchanged. The code itself is as secure as can be made, but remember, your currency only exists in computers as bits and bytes. What happens if you accidentally throw away your hard drive, or your digital storage company has an unintended error and irretrievably locks you out of your digital wallet? These errors have been reported recently, and cryptocurrency owners have lost hundreds of millions of dollars.1https://money.cnn.com/2013/11/29/news/bitcoin-haul-landfill/2https://www.fastcompany.com/40505199/bitcoin-heist-adds-77-million-to-hacked-hauls-of-15-billion Because cryptocurrency is still in its relative infancy, there is very little regulation and oversight. The digital value is gone, probably for good.
4. Buying and Selling: You buy and sell digital currency using downloaded software. It’s as simple as that. Oh, wait—it really isn’t that simple—if you want to only buy one specific type of cryptocurrency, you can download one specific app. If you want to buy and sell other cryptocurrencies, you need other apps, and there are dozens of choices. You’ll also need wallet software to hold your digital coins after you buy them, and again, there are dozens to choose from, depending on what cryptocurrency you want to hold. You will need to mix and match accordingly.
5. Taxes: Ah, you thought you didn’t have to think about this part, didn’t you! The IRS has not put out much guidance on cryptocurrency, but what they have makes it clear that the IRS considers cryptocurrency a capital asset (like stocks, for example) and taxes you just as if you made a profit or loss on the sale of a stock. However, it is often not even possible to keep track of your gain or loss due to the ethereal nature of cryptocurrency—it only exists in computers, when the transaction is confirmed. This may not be as big an issue if you are buying or selling larger amounts as investments, but what if you wanted to pay 0.0001 bitcoin for a drive-thru burger? When you exchanged that fraction of a bitcoin for a burger, how much did you gain or lose? The IRS wants you to report that, and so far, they have not set a minimum transaction amount to report. According to recent data from the IRS,3http://fortune.com/2017/03/19/irs-bitcoin-lawsuit/ only 807 taxpayers reported transactions related to bitcoin in the year 2013, 893 in 2014, and 802 in 2015. The IRS does not think those numbers reflect the number of taxpayers actually making transactions. When the IRS thinks something is underreported, they put more effort into enforcement, and they recently won a court case forcing one of the wallet software providers to turn over transaction data to the IRS.4https://techcrunch.com/2017/11/29/coinbase-internal-revenue-service-taxation/ It’s reasonable to think more scrutiny is coming.
Investing in and using cryptocurrencies only seems to be growing, but before you jump in, learn more about them. Talk to your tax advisor and your broker, and research what you’re getting in to. If it looks interesting and matches your goals, invest wisely.
By Cliff Acheson, CPA
References