What you need to know about cryptocurrency
There’s a lot of buzz surrounding cryptocurrency these days, inspiring our recent podcast Cryptocurrency: An Introduction. Bitcoin, the first cryptocurrency, has been around for a decade. Yet crypto is still a mystery to most. There are over 15,000 different cryptocurrencies available! But only around 16% of Americans say they have invested/traded in crypto. However, some platforms such as Bitcoin and Ethereum have exploded in value from just a few years ago, enticing more investors and novices. If you haven’t yet explored crypto, should you consider investing? What are some risks? How should you report your transactions to the IRS? Let’s explore.
De-Fi
Cryptocurrency is virtual currency existing on the internet. Unlike traditional currency, crypto is decentralized, meaning it isn’t under a single entity’s control. In this sense, cryptocurrencies don’t belong to any one country and can’t be controlled by a government or bank. Think of the US Dollar. The US government created it and regulates it. Conversely, crypto is part of a broader concept called decentralized finance (DeFi). DeFi removes bank control over money and financial services. It is secured through cryptography using blockchain technology. In simple terms, it uses an encryption technology that keeps transactions secure and an algorithm that eliminates the need for middlemen. It makes it impossible to counterfeit transactions or double-spend, which happens quite frequently with traditional currency. It also allows borrowing without the need for a bank.
Blockchain
As its name suggests, you can view the blockchain as a set of connected blocks or an online ledger. Each block holds information about a set of transactions and is verified independently by each member (computer) in the network. Once a transaction is formed, it can’t be changed, making forgery nearly impossible. But blockchain is not just for crypto. Companies are researching many uses for this technology including banking, medical records, and self-driving cars.
Storage
Despite the secure technology behind crypto, there is risk when it comes to storing your coin. You have several options to safely store your crypto, each with its pros and cons.
Cold-storage options mean putting your coin on a hard drive or USB drive that is not connected to the internet. Third-party companies such as Trezor and Ledger make very secure hardware wallets. This is the preferred method to store large quantities of crypto. It’s safe from online theft so long as there is some antivirus software in place. Unfortunately, hardware wallets can be lost, stolen, or damaged. This means the coin stored on the device may be lost forever.
With hot-storage, or cloud-based storage, you use a third-party app or digital wallet. Digital wallets shouldn’t be used to store large amounts of crypto. Rather, use digital wallets only to store small amounts for trade or transactions. Some popular examples include Coinbase wallet, Kraken, and Exodus.
Tax Treatment
The IRS treats gains and losses from exchanging crypto like selling stocks or real property. This means that if you buy a coin for $20,000 and sell for $40,000 you realize a taxable capital gain of $20,000. It may be either long-term or short-term depending on your holding period. The IRS’s desire would be to require annual disclosure from the crypto exchanges–1099s of some sort. But it doesn’t have the resources or means currently to crackdown on crypto exchanges.
But this doesn’t mean you can avoid reporting your gains. Crypto operates on an “open-ledger” which means that all transactions are visible to the public and thus to the IRS. The IRS is currently slow to enact any changes to the law regarding the tax treatment of virtual currencies. However, it has encouraged exchanges such as Coinbase to report transactions over $20,000. Some exchanges may voluntarily comply with this request by sending a 1099.
Wrap-up
Ultimately your decision to invest…or not…in crypto will depend on many factors. Is there value in the underlying technology of crypto which determines if there is value in crypto itself? Is the idea of decentralized finance important to you? How will a crypto investment affect your overall financial health? Consider making a conscious decision before investing. Don’t let the complexities steer you away from the discussion.