You cannot scroll through the news or social media today without reading about cryptocurrency, which in early 2021 reached a market capitalization of more than $2 trillion. Despite this trading volume and widespread news coverage, cryptocurrency continues to be a volatile investment and a target of IRS tax compliance. Here’s a crash course in everything you need to know about how cryptocurrency.
Cryptocurrency is a form of digital money with no tangible, physical form. It is created (or “mined”) and stored digitally on a specialized public network of computer systems where users may access the platform like cash and transfer it electronically to others to buy goods, services or other cryptocurrency. Users may buy and sell virtual currency as an investment on an exchange, such as Coinbase, in the same way they would buy and sell gold or other commodities. However, it is important to remember that cryptocurrency does not satisfy the legal definition of money. Instead, the IRS treats it as property subject to federal income and capital gains taxes, depending on how it is used.
You may use paper money, such as U.S. dollars, to buy bitcoin (BTC), etherium (ETH), dogecoin (DOGE) or any of the other nearly 4,000 types of virtual currency, or you may acquire it by accepting it as payment for goods and service. However, unlike the dollar or other traditional forms of currency issued and controlled by a government entity or central bank, cryptocurrency is not currently subject to regulatory oversight from a centralized authority.
Rather, a digital ledger records and tracks all cryptocurrency transactions, known as blocks, using complex mathematical algorithms that super computers on the shared network compete with to solve. The miner that finds the solution is rewarded in Bitcoin or other currency only after the other miners validate the solution. At that point, the block is added to the shared digital ledger using cryptographic techniques. As new blocks are added and linked, they create a blockchain, and the digital ledger continues to grow exponentially.
Blockchain is essentially the one record that links together and records the movement of all cryptocurrency transactions. Because each transaction is uniquely time-stamped, traceable and readily available for all users to see, blockchain technology has the potential to disrupt how businesses will operate in the future. For example, blockchain applications are already making an impact and improving the efficiency of businesses tracking orders in the supply chain, managing logistics and even managing retail sales. According to Gartner Group, blockchain technology and its ability to manage vast amounts of data could generate an estimated $3.1 trillion in new business value by 2030.
Every investment involves risk, and cryptocurrency is no different. However, because virtual currency and other digital assets like nonfungible tokens (NFTs) do not fit within any traditional asset class, they cannot be assessed with traditional metrics, such as earnings and revenue, book value or P/E ratio. Similarly, owners of crypto assets cannot rely on traditional market fundamental, such as interest rate movement, employment numbers or the consumer price index, to understand where the crypto market may be heading nor to develop sound investment strategies intended to build wealth. Rather, cryptocurrency pricing over the years has been impacted by a wide variety of changing factors that contribute to it high volatility and tremendous swings that result in significant losses for many investors.
Another risk of investing in cryptocurrency is that there is no regulatory agency dedicated to overseeing transactions involving their use, leaving investors and cryptocurrency exchanges exposed to security breaches, hacks and targeted phishing attempts designed to steal investor’s tokens. Moreover, there is no unified, worldwide standard of legal, tax and accounting best practices for managing or reporting cryptocurrency transactions. In the U.S., however, the IRS has made it abundantly clear that cryptocurrency transactions are taxable events, going so far as requiring cryptocurrency reporting to the top half of individuals’ 2020 tax returns.
Despite its cult-like following, investment in cryptocurrencies is complicated and rife with risks. Investors should consult with their advisors to understand if digital assets fit within their overall strategy for building and preserving wealth in the most tax efficient manner.
About the Author: Morgan Hill is an investment analyst with Provenance Wealth Advisors (PWA), an Independent Registered Investment advisor affiliated with Berkowitz Pollack Brant Advisors + CPAs and a registered representative with Raymond James Financial Services. He can be reached at the firm’s Fort Lauderdale, Fla., office at (954) 712-8888 or via email at email@example.com.
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This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. Any opinions are those of the advisors of PWA and not necessarily those of Raymond James. You should discuss any legal matters with the appropriate professional. Prior to making an investment decision, please consult with your financial advisor about your individual situation.
The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Investments mentioned may not be suitable for all investors. Every investor’s situation is unique, and you should consider your investment goals, risk tolerance and time horizon before making any investment. Investing involves risk and you may incur a profit or loss regardless of strategy selected.
Prior to making an investment decision, please consult with your financial advisor about your individual situation. The prominent underlying risk of using bitcoin as a medium of exchange is that it is not authorized or regulated by any central bank. Bitcoin issuers are not registered with the SEC, and the bitcoin marketplace is currently unregulated. Bitcoin and other cryptocurrencies are a very speculative investment and involves a high degree of risk. Investors must have the financial ability, sophistication/experience and willingness to bear the risks of an investment, and a potential total loss of their investment.
Posted on August 18, 2021