For a growing number of investors, cryptocurrency is not only the future of money, but also an attractive and potentially profitable investment asset, though highly risky and volatile. Bitcoin has become the public’s most visible and popular cryptocurrency and it is also among the oldest, having first emerged in 2009. Over one year, the market capitalization for bitcoin has increased enormously, from around $7.16 billion in May 2016 to $27.9 billion today. As the price of bitcoin has risen over the last year or so, so has the confidence among investors, including retirement account investors.
The process of buying cryptocurrency is still somewhat unclear for a lot of people. It’s not a stock or a traditional investment. For most people in the U.S., Coinbase would be the easiest option to buy cryptocurrency, such as bitcoin, Ethereum, or Litecoin. After verifying the account, the investor can add a number of payment methods including credit or debit cards, U.S. bank accounts, or even wire transfers of funds. Cryptocurrency transactions are not anonymous and the identify of the currency owner can be traced back to a real-world identity.
As a cryptocurrency, bitcoin is generated through the process of “mining”—essentially using your computer’s processing power to solve complex algorithms called “blocks.” One can buy and sell bitcoin on an exchange, much like a physical currency exchange, converting wealth from bitcoin to US dollars to other national currencies, back to dollars or bitcoin. And that’s how money is made.
Even though bitcoin is labeled as a “cryptocurrency”, from a federal income tax standpoint, bitcoin 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 bitcoin. 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 bitcoin, 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 bitcoins and other virtual currencies as property and not currency, the IRS is imposing extensive record-keeping rules—and significant taxes—on its use.
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 takes 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 bitcoin, could allow the investor to defer or even eliminate in the case of a Roth, any tax due from the investment. Note – retirement account investors interested in mining bitcoins versus trading, could become subject to the unrelated business taxable income tax rules if the “mining” constituted a trade or business.