Cryptocurrency has been dubbed the future of money. But what is it and how big a wallet do you need for it? Here we try to explain what this digital money is and why you should care.
What is Cryptocurrency?
Cryptocurrency is a decentralized form of currency traded entirely online. Currently, there are more than 6,700 different types of cryptocurrencies being traded with a combined value of over $2.2 trillion. When it comes to cryptocurrency there are no physical dollars or coins and no government to oversee and regulate it. Bitcoin, which was the first cryptocurrency launched in 2009, accounts for just over $1.2 trillion of the cryptocurrency market. Entrepreneur Elon Musk is one of Bitcoin’s largest investors and is considered to be its greatest influencer. Cryptocurrency has become increasingly popular in recent years as an investment. The market is volatile and has led to large returns for some investors.
Ways to Obtain Cryptocurrency
Buying cryptocurrency is the easiest and most popular way to add it to your portfolio. A buyer can go to a bitcoin ATM online or use exchange websites like Coinbase. Coinbase works similar to stock exchange websites like Robinhood; however, instead of buying and selling stocks it is buying and selling different types of cryptocurrencies. Mining is one of the hardest ways to obtain cryptocurrency. There is a finite amount of cryptocurrency and not all cryptocurrency coins are available to the market because they have to be mined first. To mine the currency a person has to use his/her computer to solve different complex equations and open the block of currency to the public. The person who retrieves the block gets to keep a portion of the cryptocurrency. Other ways to receive cryptocurrencies include performing tasks for new cryptocurrency companies as part of marketing campaigns, accepting cryptocurrency as a form of payment for services, and using cryptocurrency and cryptocurrency payment platforms.
How is it Taxed?
Like most investments, cryptocurrency is a taxable investment. IRS notice 2014-21 ruled that cryptocurrency would be treated as a capital asset. This means whenever a cryptocurrency is sold at a profit the seller will incur capital gains tax. Any cryptocurrency held by the investor for less than a year will be taxed at the seller’s normal income tax rate as short-term gains. Any cryptocurrency held by the investor longer than a year will be taxed at a long-term capital gains rate based on the seller’s annual income. However, there are exceptions based on how the cryptocurrency was obtained. If the cryptocurrency was obtained through mining, as payment for goods or services, or as a reward the owner owes tax on the entire value of the cryptocurrency from the day it was received. These can also be subject to double tax. In these circumstances when the holder decides to sell the cryptocurrency if there is a gain, it is still subject to either short-term capital gain or long-term capital gain tax.
Because cryptocurrencies are taxed as capital gains the same tax savings strategies apply to cryptocurrency as stocks. The first way to save tax on cryptocurrency is to hold your short -term gains for over a year until they turn into long-term gains. By holding your cryptocurrency gains for over a year the profit will be taxed at a lower rate. Offsetting capital gains with capital losses is another useful strategy to lower a person’s taxable income. Up to $3,000 of losses can be offset per year and any amount over that can be rolled forward to help in upcoming years. Cryptocurrency can also be invested in a Self-Directed IRA (SDIRA). A normal SDIRA will allow the taxpayer to defer the tax until they take the distribution from the account. Usually, distributions are taken after retirement leading to lower income and a lower tax rate. Gifting the cryptocurrency is another useful strategy. The IRS will allow tax-free gifts of up to $15,000 per family member each year. Unfortunately, the family members who receive the gift will have to pay tax on it. A way to avoid this tax would be to add the cryptocurrency to part of your estate. The Estate and its beneficiaries would receive a step-up in basis reducing their tax liability. Lastly, cryptocurrency can be donated to charity. Donated cryptocurrency will not be taxed and is considered an itemized deduction on your tax return.
So, before you decide if cryptocurrency is the future of your money, contact Bernicker, Eiger & Lang, CPA and we can help you consider the tax implications.