Bitcoin And Cryptocurrency Considerations

Christopher Ingle

As virtual currency becomes more mainstream it has likewise become more commonly included in the asset portfolios of serious investors and individuals with large estates. Courts and legislatures have been predictably slow in clarifying the legal consequences of these investments, but the IRS has already adopted a very specific policy toward the asset. Investors should be aware of the potential tax and security consequences before or after purchasing cryptocurrency.

Cryptocurrency is “Property”

Cryptocurrency works like cash because it can be used in purchasing goods and services and is often marketed as “currency” for the future. The United States government, including the IRS, intends that it will treat the asset as “personal property” akin to a stock or bond, and carrying the same tax implications.

Both the IRS and the few courts addressing the issue have agreed that cryptocurrency is personal property, and not cash or a cash equivalent. In 2014, the IRS released Notice 2014-21, warning virtual currency holders that cryptocurrency would be treated as property for federal tax purposes. The United States District Court for the District of Maryland similarly recognized Bitcoin, in particular, as personal property subject to a civil forfeiture statute. See U.S. v. 50.44 Bitcoins, 2016 WL 3049166 (D. Md. 2016). International courts addressing the issue, such as Singapore’s International Commercial Court, have come to the same conclusion. This distinction may result in cryptocurrency holders incurring significant income tax liability upon divestment.

Income Taxation On Capital Gains

As an intangible asset, cryptocurrency is taxed in the same manner as other intangible assets, such as stocks. If investors are fortunate enough to see the value of their virtual wallet rise, then the profits they realize are taxable as income. Complicating matters is that the asset is highly liquid and transferrable by nature. Many cryptocurrency users see the asset as a way to purchase goods and services, as they would with any other “currency,” but the IRS views these transactions as an investor realizing taxable income through profitable divestment. Last Spring, the IRS distributed letters to thousands of cryptocurrency purchasers warning them of potential tax consequences associated with buying cryptocurrency and subsequently liquidating it through purchases.

The problem may be particularly severe for long-term investors in popular cryptocurrencies such as Bitcoin. Since November 2015, the price of a single Bitcoin has spiked from $327.00 to more than $8,200.00 today, after reaching highs of about $20,000 in December 2017. The tax consequences for investors who have realized a profit may be severe. As addressed in the IRS’s correspondence to cryptocurrency purchasers, the exchange of cryptocurrency for goods, services, or even other intangible assets is being considered as a divestment and realization of profit from personal property, and therefore should have been reported as taxable income during the years these transactions took place. The goal of the IRS is clear and simple: pressure crypto purchasers into reviewing these transactions, amending their returns, and paying back taxes if necessary, under U.S. law.

Passcodes, Security, and Necessary Precautions

Investors should also understand the unique security measures involved with this asset. Most cryptocurrencies utilize a security feature wherein users are given a unique passcode derived from a complex algorithm. The passcode—usually a long string of numbers and letters—is necessary for users trying to access their wallet. Unlike most online passwords, however, users cannot recover their credentials later through a “forgot password” feature. If a user forgets, misplaces, or incorrectly writes down their complex passcode, then they may lose their investment, or alternatively, be forced to hire one of a limited number of “friendly hackers” to attempt to hack into their own wallet. Neither route is ideal, which makes passcode accessibility crucial.

Eventually, this feature may wreak havoc in probate court proceedings. If an investor passes away unexpectedly, without making the passcode accessible to a trusted representative, then heirs may be left with no way of claiming the asset. This problem was revealed on a larger scale when an entire cryptocurrency exchange—worth $190 million—allegedly became inaccessible when the exchange’s founder died without any other person having access to the exchange’s “cold storage.” The resulting fiasco has led to the company, QuadrigaCX, filing for bankruptcy and creditor protection, and roughly 115,000 affected users watching their investments disappear into an unbreakable virtual safe housed inside the deceased owner’s laptop. Responsible cryptocurrency management requires balancing security with accessibility given the asset’s unique passcode feature.

This article is not legal advice and is intended for general informational purposes. You should consult with legal counsel to determine how the information provided herein affects you.

About the Author: Chris Ingle devotes substantial time to business and intellectual property issues, including cryptocurrency.