An Overview of Cryptocurrency

Hello, readers! Welcome back to the Hoods Tax & Accounting blog! We’re delighted to be able to share up-to-date information about taxes, savings, and financial literacy—giving you the tools you need to meet your short and long-term goals. Whether you’re managing taxes for your small business or wondering how to take advantage of certain tax credits, we’ve got you covered! Our previous post delves into the benefits of a 529 savings plan. If you’re saving for your education or your child’s education and would like to utilize a tax-advantaged account, our last article will tell you everything you need to know! 
 
Today, we begin the first part in our series on cryptocurrency. Cryptocurrency is a hot topic and you might’ve seen a few news stories about new forms of cryptocurrency emerging and gaining popularity. In future posts, we’ll discuss the difference between certain types of cryptocurrency, as well as the risks and benefits involved in obtaining cryptocurrency. In this post, however, we want to give you an easy-to-understand overview of what cryptocurrency is. As well, we’ll dip our toe into the still-murky waters of tax law concerning cryptocurrency. None of the information in this article is financial advice, nor do we encourage you to invest in cryptocurrency. Our objective is to give you a comprehensive understanding of this new technology and its possible implications for our society. If you’re interested in learning more, keep reading!
 
What is cryptocurrency?
 
Cryptocurrency isn’t as mystifying as it first appears. In simple terms, cryptocurrency is a digital asset. Like your home is a real estate asset or the cash in your pocket is a liquid asset, cryptocurrency is based in the digital (or virtual) sphere. Similar to how dollars used to be backed by gold and silver, cryptocurrency is secured by cryptography. Cryptography is the “art of writing or solving codes. If you’ve ever seen ‘National Treasure’ or ‘The Imitation Game,’ you’ve witnessed cryptography in action. During the first world war, to ensure messages remained secure from the Central Powers, the Allied Powers used rotor cipher machines. During World War II, the Allies and the Axis used computers to encrypt their messages. The way encryption works is pretty straightforward. You begin with plain text. This plain text is when encrypted using an encryption key (i.e. secret algorithm). Without the encryption key, the text cannot be decoded from its unintelligible state. 
 
This encryption makes cryptocurrencies one of the most secure forms of currency, since it's nearly impossible to counterfeit or double-spend. The encryption which secures cryptocurrency exists on a decentralized network. A decentralized network means each node within the network (i.e. computer) has decision-making authority or necessary software capabilities; as opposed to a centralized network, in which instance control can rest in the hands of one individual, government, or organization. The decentralized network is based on blockchain technology, which we’ll discuss later on in this series. 
 
For the reasons stated above, cryptocurrency began as a currency which was not issued by a central authority and thus—theoretically—not subject to the control of a single government. This primary philosophy has resulted in cryptocurrency being used for illegal purposes, including to escape taxes. In the next section, we’ll discuss the societal implications of cryptocurrency, both positive and negative. 
 
Instead of dollars or bills, an individual unit of cryptocurrency is referred to as a “token.” Using a cryptocurrency system, sums of money can be easily transferred without the involvement of a third party (such as a bank or other financial institution). Instead, a user has both a “public key” and a “private key,” which serve as their unique signature to approve financial transactions. There are negligible fees associated with these transactions, as well. 
 
You might be wondering: How does cryptocurrency make money? This is an article in and of itself, as there are a few ways to make money from mining and investing in cryptocurrencies. We’ll cover this in more detail in the future, so make sure you return for the rest of the series! 
 
What potential does cryptocurrency have for our society?
 
Cryptocurrency has the potential to revolutionize the way financial institutions and law operate in our society. Major institutions, such as JPMorgan and Chase, view cryptocurrency as an opportunity to streamline payment processing and lower associated fees. For others, the long term implications could include online voting and crowdfunding. Below, we’ll discuss the major benefits and drawbacks of cryptocurrency becoming the way we spend our money. 
 
    Potential Positives
 
The inflation rate for the U.S. dollar in 2020 was one-point-four percent. Inflation is the process of rising prices which results in the devaluation of individual units of currency. Or: Your money gradually lessens in value year after year. One of the potential benefits of cryptocurrency is its inflation resistance. For example, there are only twenty-one billion bitcoins in existence. Unlike the dollar, new bitcoins are not created to manipulate the value of the currency. 
 
Cryptocurrency is also lauded for its portability and divisibility. Cryptocurrency exists only in a virtual capacity. Therefore, unlike cash or large tangible assets (e.g. cars, houses, boats), the currency can be easily transferred or accessed by anyone with a computer. Similarly, most cryptocurrencies are infinitely divisible. While the dollar can be split into quarters, dimes, nickels, and cents—cryptocurrency can be into infinitesimally small fractions of itself. 
 
    Potential Negatives
 
As we briefly mentioned above, the anonymity of cryptocurrencies encoded networks allows a relatively safe haven for criminals and those seeking to evade paying taxes. In the next section, we’ll discuss how the IRS is attempting to crack down on cryptocurrency as an industry. Besides its potential to offer refuge to criminals, cryptocurrency can also be extremely volatile. Much of a cryptocurrencies value is tied to its perceived value, meaning this metric can vacillate with news events. Most currencies gain and lose value this way, but since cryptocurrency is digital and can be easily divested from, this volatility is much more drastic. 
 
Likewise, since cryptocurrency is digital, the currency is susceptible to digital attacks. Vulnerabilities within the blockchain software are prime targets for hackers, bugs, and malware. If a cryptocurrency is compromised, countless individuals' private information and funds are up for grabs. However, this is a problem faced by cryptocurrencies and financial institutions alike as we move into an age when most robberies are cyber-based.
 
Current Tax Law Concerning Cryptocurrency
 
According to a notice issued by the IRS in 2014 (2014-21, 2014-16 I.R.B. 938), virtual currencies are treated as property for Federal income tax purposes. Therefore, capital gains and losses must be reported. Until now, cryptocurrency has been largely difficult to track and tax. This inability contributes to a gap between how much money the IRS collects and how much money the IRS estimates is due. The cryptocurrency market is worth nearly two trillion dollars; and, at certain times during this year, three trillion dollars. The latest infrastructure bill, which was passed in the Senate on August 10th, includes a new requirement for brokers to report gains and losses to the IRS. This clause stirred discontent within the cryptocurrency community, fostering a fear of intense oversight and reporting obligations. The U.S. Department of Treasury has since clarified its definition of a brokerage includes “entities that transfer digital assets on behalf of another person.”  As well, reporting rules will not go into effect until 2023. Lawmakers hope new reporting rules will help raise money for planned infrastructure (estimated to cost one-trillion dollars) over the next ten years. 
 
 
We’ve only just scratched the surface with what cryptocurrency has to offer. We hope this article provided an uncomplicated entry point into the world of cryptocurrency. Make sure you come back for the upcoming portion of our series, where we will differentiate between multiple forms of cryptocurrencies and discuss how individuals make money from digital currency. We’ll also cover a host of need-to-know terms. Stay tuned! 
 
As always, we’re happy to be able to provide you with the most relevant, up-to-date tax information for you and your family. From savings plans to tax credits to business acumen, the Hoods Tax & Accounting blog is your one-stop shop for everything you need. We offer tax preparation, bookkeeping, payroll, and QuickBooks services. If you have any questions or are interested in a consultation, please reach out! We do offer virtual consultations over Zoom, as part of our effort to accommodate everyone in these trying times. We look forward to hearing from you! Until next time, thank you for reading!
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