Cryptocurrency Basics

Cryptocurrency has been in the news a lot lately as it continues to gain traction as an alternative currency. Many are considering whether this is the time to invest in or start using cryptocurrency. After all, the IRS has taken notice and has instituted measures to ensure income from cryptocurrency is accurately reported.

Important terminology

Before you enter the cryptocurrency market, basic terminology should be understood.

• Fiat money: Fiat money is government-issued currency, like the U.S. dollar or the European euro. Fiat money is not backed by a physical commodity, such as gold or silver, but rather by the government that issues it. The value of fiat money is derived from the relationship between supply and demand, as well as the stability of the issuing government, rather than the worth of a commodity backing it.
• Cryptocurrency: Cryptocurrency is decentralized digital money that is made possible by blockchain technology. It is not managed by a central authority. Instead, it is managed by cryptocurrency users. The most well-known cryptocurrencies are Bitcoin and Ethereum. However, there are more than 5,000 cryptocurrencies on the market today. Although this is starting to change, most sellers do not accept cryptocurrency as a form of payment.
• Stablecoins: Stablecoins are a hybrid of fiat currency and cryptocurrency. Stablecoins can be used for mainstream commerce around the globe. There are three kinds of stablecoins:

1. Fiat-collateralized stablecoins maintain a reserve that acts as collateral. The reserve may be in the form of a fiat currency, a precious metal like gold, or a commodity like oil. Most fiat-collateralized stablecoins are maintained by independent custodians. They are regularly audited as well.
2. Crypto-collateralized stablecoins are more volatile than fiat-backed stablecoins because their reserve comprises other cryptocurrencies.
3. Noncollateralized or algorithmic stablecoins do not maintain a reserve. Instead, they include a working mechanism, such as a consensus mechanism, to maintain a stable price. Any actions are backed by autonomous smart contracts that are housed on a blockchain. The contracts, which are basically agreements between buyers and sellers, are written directly into lines of code that then control transactions.

• Blockchains: Blockchains are open distributed ledgers that record cryptocurrency and stablecoin transactions in code. Each transaction is encoded in something called a block, and these blocks are then linked with other blocks on a chain of previous cryptocurrency transactions. These transactions cannot be changed, making them very secure and impervious to fraud.

Keep in mind that these are basic definitions that do not delve into the nuances of the terms or their meanings.

Taxation of cryptocurrency

Cryptocurrency transactions are taxed as capital assets. That means they can be classified as business property, like in the case of mining, as well as either investment property or personal property. If you earn cryptocurrency from mining, receive it as a reward, or for payment of goods or services, you will owe tax on its fair market value on the day you receive it. If you later sell or trade cryptocurrency that you earned or purchased, tax is incurred if there is a gain. If there is a loss, the tax deduction allowed will depend on whether it is classified as a business, investment, or personal transaction.

In general, the amount of tax on your transactions will depend on the fair market value of the cryptocurrency the day you received it. The fair market value is measured in US dollars.

If you have questions about taxation of cryptocurrency, contact R&A.