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Cryptocurrency Risk and Tax Considerations for Investors

By: Dean Dorton | June 15, 2021

As cryptocurrency seems to be gaining in popularity, there are a couple of issues we believe investors should know about before getting involved with one or more of the proliferating number of cryptocurrencies, such as Bitcoin, Ethereum, and Litecoin

2021 Summer Edition | Forensic Accounting | Tax

By: Elizabeth Woodward, CPA/CFF, CFE | ewoodward@deandorton.com and Joe Daugherty, CPA | jdaugherty@deandorton.com 

As cryptocurrency seems to be gaining in popularity, there are a couple of issues we believe investors should know about before getting involved with one or more of the proliferating number of cryptocurrencies, such as Bitcoin, Ethereum, and Litecoin. If you aren’t already educated about cryptocurrencies, a good starting place may be the Federal Trade Commission’s website, https://www.consumer.ftc.gov/articles/what-know-about-cryptocurrency-and-scams.

This article is by no means a complete discussion of the things people who are involved with cryptocurrency should know. It is intended to touch upon only a couple of relevant considerations.

One Risk of Cryptocurrency

Earlier this year, Elizabeth Woodward received a phone call from a colleague with what she first thought was a simple forensic accounting matter. Elizabeth’s colleague’s family member had died unexpectedly and there was some evidence that the deceased family member had invested in a cryptocurrency. But, no “private key” (cryptocurrency password) had been found to access the account. Without the private key, the estate’s executor wondered who he could contact to get the private key to know the value of the account and to make appropriate disposition of it to the estate’s beneficiaries.

After making some inquiries and doing a little research, Elizabeth’s answer to the executor’s question was “no one.” Cryptocurrency cannot be claimed without the private key. Maybe the cryptocurrency industry will develop a system to help with his kind of problem in the future. One risk of cryptocurrency is that a fraudulent person reaches out to a family member inquiring about cryptocurrency assets, promising to help – for a fee – and then fails to deliver. Cryptocurrencies are not backed by any government, so purchases, sales, exchanges, and other transactions involving cryptocurrencies are private transactions. It is important to consider both the risk of fraudulent people offering help with finding cryptocurrency and the risk of what happens to cryptocurrency when a family member with cryptocurrency assets dies.

Tax Basics of Cryptocurrency

The fundamental tax issue regarding cryptocurrencies is whether they should be viewed as cash or other property. The Internal Revenue Code does not address this issue, but in 2014 the IRS issued its position that cryptocurrencies are non-cash property for tax purposes. The implications of this are very significant. If someone, say, buys $25,000 worth of Bitcoins, it is viewed the same as buying $25,000 worth of Apple shares. Thus, when those Bitcoins are sold, the seller normally will recognize a capital gain or loss, which may be short- or long-term, depending on the familiar holding period rules. But, what if those Bitcoins instead are used to purchase something else, perhaps another cryptocurrency or other property? That transaction also would be a recognition transaction for tax purposes, with the gain or loss being measured by the value of the Bitcoins used, expressed in U. S. Dollars, at the time they are used in relation to their value, again expressed in U.S Dollars, when the Bitcoins were acquired.

For someone who is very active in buying or selling cryptocurrencies and in receiving or using them for property or services, accounting for these transactions can be very challenging.

We anticipate that the IRS will be enhancing third-party reporting rules and increasing its scrutiny of cryptocurrency transactions to reduce noncompliance with its rules.

Final Thoughts Regarding Today’s State of Cryptocurrency

Whether someone views cryptocurrency as an investment or as pure speculation, or with characteristics of each, we believe those who get involved with cryptocurrency first should become educated about its fundamentals, risks, and tax treatment.

This article was originally published in News & Views (Dean Dorton’s quarterly newsletter).

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