Most people are familiar with Bitcoin by now, and you might have heard of Ethereum, too. But those are just two of the many thousands (over 8,000 as of January 2022) of cryptocurrencies vying to be the next best thing.
It is common knowledge that cryptocurrency is a type of digital currency that exists electronically and is not issued by any government or bank. It relies on free – market mechanisms to determine its value, meaning that it is worth what people are willing to pay for it.
A cryptocurrency (or crypto) can be used to buy goods and services and uses an online ledger with strong cryptography to secure online transactions. Many companies have issued their own currencies, often called tokens, and these can be traded specifically for the good or service that the company provides. Think of them as arcade tokens or casino chips. You will need to exchange real currency for the cryptocurrency to access the goods or services.
Cryptocurrencies are popular for a variety of reasons. Supporters see them as the currency of the future and are racing to buy them now, presumably before they become more valuable. Other supporters like the technology behind cryptocurrencies, the blockchain, because it is a decentralized processing and recording system and can be more secure than traditional payment systems. Think of the blockchain as a checkbook for crypto. For any given crypto, it records how many units there are, who owns them, who spends them, and when. Part of the appeal of this technology is its security.
All cryptocurrencies are created by code, which determines every function associated with them; from the way data is stored and how transactions are recorded to the distribution of mining rewards and the maximum supply of tokens produced. In most cases, the code is public, and the software used to generate a given cryptocurrency is decentralized, just like the cryptocurrency itself. That public, decentralized software is hosted on individual computers all over the world instead of on a central server. Once entered the blockchain, no one can ever change an entry in the database without meeting specific conditions. Everyone involved can see the public record of all transactions.
To buy cryptocurrencies, you will need a “wallet,” an online app that can hold your currency. Generally, you create an account on an exchange, and then you can transfer real money to buy cryptocurrencies. While some cryptocurrencies, including Bitcoin, are available for purchase with U.S. dollars, others require that you pay with bitcoins or another cryptocurrency. There are other ways to acquire cryptos too. In most cases, the algorithms that fuel the crypto factory are written to award token to computers that add transactions to the blockchain. That process is known as mining. Miners use special hardware and the cryptocurrency’s public, decentralized software to add transactions to blockchain. In exchange for providing that critical blockchain maintenance, miners get paid in new crypto tokens. Most crypto coins or tokens are created this way. Anyone can be a miner, but it is a largely fruitless endeavor for most. It is complicated, competitive, and expensive if you fail. In fact, there is so much processing power needed that mining is no longer the field for enthusiasts but rather of entire companies.
Some cryptos were never designed to replace currency like the US dollar. In other words, it was never meant to be used as money. This kind of non-mineable, non-spendable crypto is usually generated to reward early investors in a new crypto launch, called an ICO (initial coin offering).
In 2021, with the price of a bitcoin briefly topping $64,000, it does seem like virtual currency is here to stay. This only emphasizes the importance of learning about this market before you invest in it.
Also, of utmost importance, is letting your tax preparer know if you acquired or disposed of a position in a virtual currency during the tax year. The IRS has been moving to refer to all forms of virtual currency as digital assets and views it as a unit of property and taxing it accordingly. Most clients will be traders of crypto assets – similar to what would be seen with traditional stocks, bonds, and mutual funds. For this type of investor, income and loss will be treated as capital gains and will be subject to ordinary and capital gains rates depending on the holding period. Additionally, this will mean that gains may also be subject to the 3.8% net investment income tax.
Due to the increases in the value of cryptocurrency, taxpayers may find it beneficial to donate cryptocurrency to charitable organizations. Similar to donating appreciated securities to charitable organizations, taxpayers can donate cryptocurrency and receive a deduction for the fair market value of the cryptocurrency at the time of donation, without having to realize the gain as taxable. The deduction for contributions of appreciated securities is limited to 30% of donor’s adjusted gross income (AGI). Donations of appreciated stock made to private foundations are limited to 20% of donor’s AGI. If the value of donation exceeds the AGI limits, there is a five-year carryforward for the excess donation.
