What You Need to Know Cryptocurrency (and Taxes) Before Investing
If you could time-travel back to mid-2011 and buy 100 bitcoin for about $1 apiece, your investment would be worth tens of millions of dollars in 2021. Cryptocurrency has had a meteoric rise over the last decade. “Should I invest in cryptocurrency?” is a common question for financial advisors to hear from their clients these days. The answer? Maybe—but only once you know exactly what you’re investing in, and what risks you’re taking.
What is cryptocurrency, exactly?
In the simplest terms, cryptocurrency is a completely digital form of currency whose value is constantly fluctuating. You can buy cryptocurrency to exchange for goods and services like you would with other kinds of currency, or hold onto it and hope it gains value as an investment vehicle.
People often think of Bitcoin as being synonymous with cryptocurrency, maybe even using these terms interchangeably. In reality, Bitcoin is essentially one brand of cryptocurrency. It’s by far the most popular but there are thousands of other types of cryptocurrency available. Ethereum, Cardano and Tether are some other popular cryptocurrencies.
How does blockchain work?
Cryptocurrency’s appeal is largely derived from the security of blockchain technology. Blockchain is a kind of digital ledger where crypto transactions are recorded. Each time you use cryptocurrency to buy something, the details of that transaction are stored in units called blocks. Each block has the storage space to record many transactions. Once a block is full, it’s linked to all the previous blocks in the chain and a new block is created.
Blockchain is decentralized, so no single organization controls it. Millions of computers have copies of the ledger and are constantly updating in real time. When you buy something with crypto, millions of computers verify and record the transaction. Hackers who want to alter a transaction record to make it look like you paid them with cryptocurrency would have to access millions of computers to do so.
How do you buy and sell cryptocurrency?
Cryptocurrency is generally purchased and sold through crypto exchanges, which function a lot like online stock trading platforms. Every exchange has its own mix of cryptocurrencies for sale and has its own fee structure. You can fund an account using bank funds, credit cards, debit cards and/or other payment sources, depending on the exchange, then use that account to buy crypto. Currency is managed in digital apps called wallets. When you want to cash out, sell your currency for cash through the same crypto exchange and either invest in more currency or transfer the money to your bank.
Or you can spend crypto instead of cash with certain businesses, though few major retailers accept it as payment. Keep in mind that every transaction is a realized gain and requires tax reporting, making it very cumbersome to actually use as a currency. And anyone trying to use it needs to understand the tax requirements.
Is cryptocurrency a good investment?
Cryptocurrency can be a lucrative investment tool, though it’s also extremely volatile. Prices can fluctuate wildly over short periods of time. In 2020 alone, Bitcoin traded for as low as around $5,000 and as high as around $29,000. Crypto’s newness contributes to its volatility. No one’s exactly sure how much it’s really worth, or what it will be worth a year or five years from now. You’ll only get a return on any investment you make in crypto if someone’s willing to buy it from you in the future, and we don’t know what future demand is going to look like.
Because it’s such a relatively new industry, investors need to look closely at the risks and rewards of cryptocurrency before buying in. The lack of regulation means buyers have little recourse when something goes wrong. While crypto is supposed to be the most secure form of currency, there have been instances of hackers finding and exploiting system vulnerabilities to steal assets. Stolen cryptocurrency is rarely recovered. In this way, your money may be safer as cash than as crypto.
How is cryptocurrency taxed?
Proactive tax planning has to be part of your crypto investment strategy. The IRS treats virtual currency as property for tax purposes. Just like with other property, you’ll owe taxes on any gains realized and may be able to deduct losses. Taxes are only owed when you sell or trade your currency, not when you buy it. If you bought $5,000 in crypto and later sold it for $7,000, you would owe taxes on the $2,000 gain. You’re taxed at your income tax rate if you owned the currency for a year or less, and at the long-term capital gains tax rate if you owned it for more than a year.
Historically, it’s been fairly easy for unscrupulous investors to shield cryptoassets from the IRS. Crypto exchanges and businesses that accept cryptocurrency haven’t been required to report transactions to the IRS, so some taxpayers have essentially been on the honor system with regards to reporting their gains or losses. But that’s set to change. Cryptocurrency taxation is addressed as part of the infrastructure bill President Biden signed into law in November 2021. The bill creates reporting requirements for brokers of digital assets, which means crypto exchanges and businesses that receive virtual currency will have to file a 1099 for any transaction above $10,000 starting in 2023.
This requirement should make it harder for tax evaders to game the system. But it may also make tax reporting more complicated for crypto investors. Brokers are able to report the value of a taxpayer’s crypto transaction but don’t know the taxpayer’s cost basis, so there may be discrepancies between what the taxpayer calculates as their gain and what the broker reports as their gain. To avoid an audit—and a lot of stress at tax time—anyone investing in cryptocurrency should be meticulous about recording their own transaction details, and work with tax planners familiar with the specific challenges around cryptocurrency.
So, should you invest in cryptocurrency? It really depends on your financial goals and personal investment philosophy. Your financial advisor almost certainly won’t recommend cashing out your retirement savings to invest in bitcoin or another digital currency. But cryptocurrency can certainly be part of a well-balanced portfolio for investors who understand the tax impact and risks involved.
Cryptocurrency investing is obviously a complex topic, and this is just a brief overview. To learn more, listen to the cryptocurrency episode of our Fine Answers podcast with special guest Tim Tully, Chief Executive Officer at ZelCore Technologies.
Sachetta’s team of financial and tax advisors are here to help clients evaluate all their investment options, including cryptocurrency. From considering virtual currency’s role in your portfolio to helping you devise a crypto tax strategy, we’re here to provide the support you need to feel comfortable with your choices. How can we help you grow your wealth and protect your family’s financial future? Contact me today!
**Investments in cryptocurrencies may carry unique and increased risks. Investors in such assets must be able to bear substantial losses to principal.
Michael is a Certified Financial Planner™ practitioner, Certified Public Accountant, and holds a Master’s Degree in Taxation from Bentley University. Mike has been involved in personal financial planning, as well as both business and individual taxation for more than 15 years. Our ideas about money are formed by our life experiences. Over the years, Mike has seen those close to him make common money mistakes from not having enough life insurance, to not doing the proper estate planning. When he received an inheritance in college and started looking into how he could use it to achieve his goals, he realized that he could use those experiences to help others. He changed his major to Finance, and the rest is history.