Approximately 145 million American adults say they own or have owned cryptocurrency. Statistically, that’s more than half of your co-workers, neighbors, and friends.
Although not regulated by any government agency, cryptocurrency is becoming mainstream. However, President Biden recently signed an executive order to address cryptocurrency risks with a whole-of-government approach that could make cryptocurrency even more attractive to investors as well as traditional banks and credit unions.
In the short term, however, the cryptocurrency remains a volatile, speculative asset that is likely to continue its heartbreaking booms and busts. That’s not to say that cryptocurrency doesn’t belong in a well-diversified portfolio, but I recommend my clients do some research on cryptocurrencies before deciding whether or not to invest.
As Warren Buffett said about investing in cryptocurrency, I get in enough trouble with the things I think I know. Why on earth would I take a long or short position in something I don’t know about?
How Cryptocurrency Works: The Basics
Suppose you order a new set of garden furniture online. A credit card company or payment processor like PayPal acts as an intermediary between you and the seller.
However, if you want to buy this patio set with cryptocurrency, there is no middleman. You conduct transactions directly with the merchant. The cryptocurrency network assigns a public key and a private key, which becomes your unique address. You then use your private key to digitally sign the transaction.
There are no bank or third-party fees. You store your cryptocurrency in either a hot or cold digital wallet. You can get a software-based hot wallet from an exchange like Coinbase or a provider like Electrum or Mycelium. A cold wallet is a small, encrypted wearable device from vendors like Trezor and Ledger Nano.
What is Blockchain?
It’s unclear which cryptocurrency names will survive, but the real value likely lies in the underlying blockchain technology. Originally created to power Bitcoin, the forefather of cryptocurrencies, today there are thousands of blockchains for digital currencies such as Ethereum, Litecoin, Dogecoin, Tether and many others.
The blockchain uses a digital ledger to duplicate and distribute your patio furniture transactions to computers across the blockchain. Peer-to-peer computer networks verify and time-stamp each transaction. Instead of a central authority like a bank with the associated costs and infrastructure, a network of users verifies the data
The growing list of records, known as blocks, are linked together using cryptography. Crypto mining verifies the next block in the blockchain. Miners are rewarded with cryptocurrency tokens plus any fees paid by the exchange parties.
Since the transaction appears on the blockchain across the entire network of computers, it is extremely difficult to alter, hack or cheat the system. For countries with poor or corrupt financial institutions, blockchain-based cryptocurrencies protect against criminal activity. There’s also an element of integrity as users can rate each other, which weeds out unscrupulous users.
This does not mean that blockchain is absolutely hack-proof. Hypothetically, if a group of miners were able to take control of more than 51% of the blockchains’ hash rate, or processing power, they could stop payments, reverse transactions, or double-spend coins.
Blockchain has a few disadvantages. All of these computers and the processes involved in mining cryptocurrency are energy guzzlers, making them polluting. Cambridge University found that Bitcoin mining uses more electricity annually than Argentina does to operate.
And because blockchains require massive amounts of computing power over a distributed network, they’re slower than centralized databases. The bitcoin blockchain can only process 4.6 transactions per second, so it takes about 10 minutes to process one bitcoin transaction. In contrast, the Visa network can process more than 1,700 transactions per second.
Blockchain is a transformative technology and has applications outside of cryptocurrency in healthcare, art, travel, law, insurance and countless others. Think of any transaction that requires a central clearinghouse, such as B. transfers or the settlement of transactions.
Beware: Tax Matters
The IRS classifies crypto as a type of property rather than currency. If you use digital currencies to buy or sell goods and services, you have to pay taxes. Using cryptocurrency can result in an unexpected tax bill.
For example, the patio furniture seller who receives your bitcoin as payment will have to pay tax on the current value. You may owe capital gains taxes if the realized value of the sale transaction is greater than the price you paid for the cryptocurrency.
Buying and holding crypto with cash is not a taxable event, but if you acquire digital currency from mining, you are immediately taxable on the value. Getting paid in crypto also triggers a tax liability. Transferring crypto from one digital wallet to another is not taxable, but exchanging one cryptocurrency for another is.
Investing in crypto also has tax implications. If you sell crypto for a profit, you will have to pay tax on the difference between the purchase price and the selling price.
If that sounds like a lot of recording, it is. The IRS requires that you keep records sufficient to identify positions taken on tax returns. That means documenting earnings, sales, exchanges and the fair market value of your crypto assets. But unlike stocks, you don’t get a 1099-B that shows you the cost basis of your transaction. When using cryptocurrency for day trading, transactions can run into the thousands.
Good news from a tax perspective is that it is possible to use tax losses to write off some losses. Like stock losses, you can deduct crypto losses from ordinary income up to $3,000 per tax year and carry forward losses over $3,000 to death.
The value of cryptocurrency is largely determined by supply and demand. Unlike government-backed (fiat) currencies, where governments have the option to print more money to increase supply, the majority of cryptocurrencies have published supply limits as per their token minting and burning plan. There will only ever be 21 million bitcoins. When demand exceeds supply, the value of cryptocurrencies increases, sometimes dramatically.
Stablecoins aim to provide a less volatile type of cryptocurrency by pegging the value of the coins to another currency, commodity, or financial instrument. For example, the USDF Consortium, a membership-based association of FDIC-insured financial institutions, is attempting to push the launch of a bank-minted tokenized deposit (USDF) pegged to the US dollar and insured for up to $250,000 by the FDIC.
A stablecoin that turned out to be not stable at all rocked the markets. TerraUSD, which relies on algorithmic coin supply management, lost its peg to the US dollar, and its Terra cryptocurrency lost 98% of its value in just 24 hours.
Protecting Your Cryptocurrency
Unlike other assets that have built-in protections like FDIC insurance, you are responsible for protecting your crypto assets. You should use two-factor authentication with a strong password and additional verification like fingerprint or face recognition. Don’t buy crypto at the local coffee shop; Use a secured internet connection.
Your digital key, a 256-bit string of alphanumeric characters, is the only way to access your crypto assets. Hope you never lose your private key. If you lose the key or throw away your cold wallet, the crypto is lost forever.
Seems unlikely? Tell that to James Howells, who accidentally trashed an old hard drive that was taken to the local landfill. He was never able to recover about $181 million in bitcoin. Or Mark Frauenfelder, who wrote his key for his hardware wallet on a piece of paper that the cleaners threw in the garbage. Or Stefan Thomas, who would have over $100 in cryptocurrency if he could remember his password.
If you die, your cryptocurrency will be treated as a probable fortune. However, because it is decentralized, your beneficiaries may not be able to access it unless you include your cryptocurrency assets in your estate plan with instructions on how to access them.
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