What is Virtual Currency?
Virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, and a store of value. In some situations, virtual currency operates like “traditional currency,” i.e., the coin and paper money of a country that is designated as legal tender.
However, it does not have legal tender status in any jurisdiction. A virtual currency is “convertible” if it has an equivalent value in traditional currency or acts as a substitute for traditional currency.
The Virtual Currency Exchange
In order to buy virtual currency with a medium of exchange denominated in a traditional currency, such as a conventional check, credit card, wire or Automated Clearing House (ACH) electronic payments, the virtual currency user will have to find some way to transfer traditional currency to someone who already has virtual currency and wishes to exchange it for traditional currency. This exchange can occur with anyone holding a virtual currency, but tends to be handled through businesses called virtual currency exchangers that trade between virtual currencies and traditional currencies.
After computers on the network confirm that a transaction is authentic, the transaction is posted to a “block,” which is a grouping of transactions. When a specified number of confirmed transactions have been grouped, a block is formed. Miners then compete against each other to find a solution to a mathematical puzzle that depends on the contents of the block. Once a solution is found, that block will be added to the blockchain. When a new block is added to the blockchain, new virtual currency coins are generated and awarded to the miner who discovered the mathematical puzzle solution that allows the new block to be added to the blockchain. The cycle then repeats. All transactions in a virtual currency blockchain can be viewed by the public on any computer connected to the Internet. However, the blockchain transactional history only reveals the date, the time, the amount (denominated in virtual currency), and the wallet addresses associated with a transaction. The blockchain does not identify the actual identities of the wallet owners. There are nearly a thousand virtual currencies, but the most widely known virtual currency, and largest by capitalization, is Bitcoin. Other virtual currencies mimicking bitcoin using the blockchain technology are known as alternative coins or Altcoins for short. Just a few examples of Altcoins are Ethereum, Litecoin, Ripple, Feathercoin, and Dogecoin.
Litecoin, launched in the year 2011, was among the initial cryptocurrencies following Bitcoin. Litecoin was created by Charlie Lee, an MIT graduate and former Google engineer. Litecoin is based on an open source global payment network that is not controlled by any central authority and uses “scrypt” as a proof of work, which can be decoded with the help of CPUs of consumer grade. Although Litecoin is like Bitcoin in many ways, it is believed to have a faster block generation rate and hence offers a faster transaction confirmation.
Like almost all digital currencies, Litecoin is produced through a process called “mining.” Miners use computers to process Litecoin transactions, which are presented as algorithms the computers must solve. When the computers solve the problems, more Litecoins are added to the network and the miners are rewarded with their shares. There are a fixed amount of Litecoin in the world – the volume of Litecoin can never exceed $84 million. After we reach that point, the coin has the ability to be broken down into minute payments.
Litecoin has gained popularity in the Fall of 2017 largely because the price of Bitcoin, the most popular form of cryptocurrency, has skyrocketed. The price of Litecoin has also exploded largely in part because it became the third currency investors could purchase on the popular digital currency exchange Coinbase and also for the following reasons:
Bitcoin was the first digital currency in the world, which has led to its popularity, but also exposed some of its shortcomings. As discussed above, blockchain technology is the foundation of all digital currencies. Litecoin actually uses this technology more efficiently than Bitcoin. The Litecoin blockchain generates a new block every 2.5 minutes. This is 7.5 minutes faster than Bitcoin can produce a block. This will likely appeal to merchants who want a faster transaction. Of course, in the world of Bitcoin, merchants can accept a payment immediately if they forgo security. In addition, the simplicity of Litecoin mining could potentially steal Bitcoin miners. It is true that Bitcoin is worth significantly more than Litecoin, but most Bitcoin mining is carried out by supercomputers. The algorithms have become too hard for everyday miners to crack. This could potentially mean that many miners tired of struggling over Bitcoin would transition over to Litecoin.
How are Cryptocurrencies Treated by the IRS?
Even though Litecoin are labeled as a “cryptocurrency”, from a federal income tax standpoint, Litecoins and other cryptocurrency are not considered a “currency.” On March 25, 2014, the IRS issued Notice 2014-21, which for the first time set forth the IRS position on the taxation of virtual currencies, such as Litecoins. According to the IRS Notice, “virtual currency is treated as property for U.S. federal tax purposes.” The Notice further stated, “general tax principles that apply to property transactions apply to transactions using virtual currency.” In other words, the IRS is treating the income or gains from the sale of a virtual currency, such as Litecoins, as a capital asset, subject to either short-term (ordinary income tax rates) or long-term capital gains tax rates, if the asset is held greater than twelve months (15% or 20% tax rates based on income). By treating Litecoins and other virtual currencies as property and not currency, the IRS is potentially imposing extensive record-keeping and tax reporting rules on its use.
Does the IRS Allow Retirement Accounts to Purchase Cryptocurrencies?
The Internal Revenue Code does not describe what a Self-Directed IRA or Solo 401(k) Plan can invest in, only what it cannot invest in. Internal Revenue Code Sections 408 & 4975 prohibit Disqualified Persons from engaging in certain types of transactions. The foundation of the prohibited transaction rules is based on the premise that investments involving an IRA and related parties are handled in a way that benefits the retirement account and not the IRA owner. The rules prohibit transactions between the IRA and certain individuals known as “disqualified persons”. The definition of a “disqualified person” (Internal Revenue Code Section 4975(e)(2)) extends into a variety of related party scenarios, but generally includes the IRA holder, any ancestors or lineal descendants of the IRA holder, and entities in which the IRA holder holds a controlling equity or management interest.
Because the IRS treats cryptocurrencies, such as Litecoins, as a capital asset, such as stocks or real estate, a retirement account is permitted to buy, sell, or hold cryptocurrencies, subject to the prohibited transaction rules found under Internal Revenue Code Section 4975(c).
Tax Advantages of Using a Self-Directed IRA LLC to Buy Litecoins
The IRS tax treatment of virtual currency has created a favorable tax environment for retirement account investors. In general, when a retirement account generates income or gains from the purchase and sale of a capital asset, such as stocks, mutual funds, real estate, etc., irrespective of whether the gain was short-term (held less than twelve months) or long-term (held greater than twelve months), the retirement account does not pay any tax on the transaction and any tax would be deferred to the future when the retirement account holder taxes a distribution (in the case of a Roth IRA or Roth 401(k) plan no tax would be due if the distribution is qualified). Hence, using retirement funds to invest in cryptocurrencies, such as Litecoins, could allow the investor to defer or even eliminate, in the case of a Roth, any tax due from the investment.
So, why use a Self-Directed IRA LLC to Buy Cryptocurrencies?
- Gains are tax-free.
- No time limit for holding property – no need to worry about 12 month holding period for long term capital gain treatment.
- Potential to earn a larger rate of return on invested capital.
- Invest in what you know and understand.
- Diversify your retirement portfolio from over-exposure to Wall Street.
- Protect your retirement funds from inflation or a falling U.S. dollar.
- Invest with privacy.
How to Use a Self-Directed IRA LLC to Invest in Cryptocurrency?
Working with IRA Financial Group to purchase cryptocurrencies, such as Bitcoins, Ethereum, Ethereum Classic, or Litecoins, with a Self-Directed IRA is quick and easy.
- Establish a Self-Directed IRA account with IRA Financial Group.
- Rollover retirement funds, cash or in-kind, tax-free to the new Self-Directed IRA account.
- The IRA assets will then be transferred to the LLC tax-free in exchange for 100% interest in the newly established IRA LLC.
- You, as manager of the LLC, will open a bank account for the LLC at any local bank. IRA Financial Group will draft an LLC Operating Agreement identifying you as manager of the LLC and the IRA as the sole member.
- You, as manager of the LLC, will then have “Checkbook Control” over all the assets/funds in the IRA LLC to make the cryptocurrency investment.
- A cryptocurrency account would be opened in the name of the IRA LLC. We have helped hundreds of clients establish cryptocurrency accounts for their Self-Directed IRA LLC at most of the popular cryptocurrency exchanges.
- You, as manager of the LLC, will then wire the IRA LLC funds to the new cryptocurrency account opened at the exchange. The account will be opened in the name of the IRA LLC.
- Since the LLC is owned 100% by an IRA, it will be treated as a disregarded entity for tax purposes. No Federal income tax return is required to be filed and all income and gains from the cryptocurrency investment will flow back to the IRA without tax.
Cryptocurrency investments, such as Litecoins, are risky and highly volatile. Any investor interested in learning more about Litecoins should do their diligence and proceed with caution.