Cryptocurrency FAQs: Answers from an Investment Advisor and a Tax Accountant
We get a lot of questions from clients about cryptocurrency. Whether you’re new to the cryptocurrency scene or already own it but don’t know exactly what to do with it, it’s important to know the tax and investment ramifications of it.
That’s why we asked two members of our team — Brian Nichols of our tax department and Steve Hannigan of GGM Wealth Advisors — to answer some common questions about cryptocurrency from both a tax and investment perspective.
Meet Brian and Steve
Steve Hannigan, CFA, is the director of investment research at GGM Wealth Advisors. He works closely with his clients’ tax advisors to provide comprehensive and integrated financial services. Steve is the author of a blog series called Understanding the Crypto-Craze.
What can I buy with cryptocurrency?
Brian: You can use cryptocurrency for just about any purchase. Of course, the seller would have to be willing to accept the cryptocurrency. The U.S. government, for example, does not accept cryptocurrency. Also, you cannot use cryptocurrency to contribute to a 401(k) or an IRA. Only U.S. dollars can be contributed to a 401(k) or an IRA. Once the contribution is made, however, you can purchase cryptocurrency in certain retirement accounts.
What cryptocurrencies are available to purchase?
Steve: There are thousands of cryptocurrencies available for investment and/or trading. The largest is Bitcoin with a market capitalization of over $1 trillion. The second largest cryptocurrency is Ether (Ethereum), which has a market capitalization of over $500 billion. On the other end of the spectrum, there are brand new cryptocurrencies that begin trading with practically no market capitalization at all.
Why is tax planning before I invest in cryptocurrency so important?
Brian: It’s important to consult with a tax professional to know which cryptocurrency transactions are taxable and which are not. For example, exchanging one type of cryptocurrency, Bitcoin, for another type of cryptocurrency, Ethereum, is a taxable event.
It is also important to put in place a system that permits you to track and collate your transactions since there is the potential for having to account for thousands of transactions in a single year.
What is one common misunderstanding about crypto from a tax angle?
Brian: A common misconception is that cryptocurrency is treated the same as cash from a tax perspective. This is incorrect.
When you use cryptocurrency to purchase a product, the IRS treats this as a sale of property. So, when you buy your $91,000 Tesla S using bitcoin, you would report a sale of $91,000 and a basis on the sale of however much it cost you to purchase the bitcoin. Most of the time the bitcoin used to purchase an item has increased in value, so you have a taxable gain. As a result, the $91,000 Tesla cost you not only the $91,000, but also the tax on the gain from the cryptocurrency you used to purchase it. Every cryptocurrency transaction has the potential to be a reportable event for tax purposes.
What is one common misunderstanding about crypto from an investment angle?
Steve: Past performance is not an indicator of future investment results. Just because a certain coin or the asset class in general has done very well in the past few years does not mean that the recent success is guaranteed to continue into the future.
What is the #1 thing I should know before I invest in crypto?
Steve: Cryptocurrencies can be very volatile. As with all investments, you should be in a position where you can lose your investment in crypto and not devastate your financial future.
What role should cryptocurrency have in my investment portfolio?
Steve: As with any investment, before purchasing cryptocurrencies an investor should take the time to map out their financial goals, and ensure that their investment mix represents the proper risk and return characteristics to ensure they will achieve those goals.
Cryptocurrencies can be added as a part of a diversified portfolio, but beware of losing diversification and potentially liquidity by becoming over exposed to the asset class.
Some investors view it as a hedge on inflation/diminishing purchasing power of fiat currencies. Others invest in cryptocurrency as a bet that the underlying technologies such as block chain will become more widely adopted.
Where do I “keep” my cryptocurrency once I buy it?
Brian: Cryptocurrency dealers, such as Coinbase, provide clients the ability to store cryptocurrency in either “wallets” or “vaults.”
Wallets are separate accounts that do not restrict the immediate use of cryptocurrency. Vaults are accounts that have additional security features such as an additional password that provide an added layer of security when using cryptocurrency.
Is cryptocurrency regulated?
Brian: You will not get a 1099B showing the sale of cryptocurrency but as of 2023 brokers will be required to report transfers of cryptocurrency and other digital assets from broker accounts to non-broker accounts. They will also have to report any transfers as a cash transfer for anti-money laundering purposes.
I plan to purchase Bitcoin. What are a few things I should be aware of before I buy?
Steve: You will need to open a digital wallet to hold your cryptocurrencies.
Make sure the service you use to trade is tracking your purchases and cost basis so you have an accurate record for calculating any potential capital gains taxes you may owe. If the service you are using does not, keep track of it yourself.
If you are planning on using Bitcoin as a currency to purchase items, make sure you research which businesses accept Bitcoin.
How does cryptocurrency differ from paper (or fiat) currencies?
Brian: While cryptocurrency and fiat currency both use the name “currency,” they are very different things. Fiat currency is issued by governments and is not backed by a specific commodity such as gold. Examples include most modern currencies such as the U.S. dollar and the euro. Fiat currencies give central banks increased control over the economy because there is no limit on the amount of fiat currency that can be printed. So, the government can decrease the value of its currency (an attempt to boost its economy) by printing more of it.
The supply of cryptocurrency, on the other hand, is fixed and there is no central bank that can simply create more supply. Bitcoin, for example, is “mined” by companies and individuals who use computers to solve extremely complex equations to create blocks on the block chain, and are rewarded with newly released bitcoin. The rate at which new bitcoins are made available to those solving the equations is set, as is the total number of bitcoins that will be released (21 million.) Therefore, a cryptocurrency’s value cannot be diminished by the government increasing supply. On the other hand, the value of a cryptocurrency coin is based solely on the supply of and demand for the coin. There is no valuable underlying asset. As a result, cryptocurrency values are very volatile and there is always a possibility that they go to zero.
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Published on January 13, 2022