Cryptocurrency - It's Time to Acknowledge the Elephant in the Room

9/20/2021 - By Joshua Jackson, CPA

I never thought I would write about cryptocurrency, but with a current global market cap of $2.13 trillion, it doesn’t really matter what I might think about it anymore. There is simply too much money in this space to ignore it any longer.

The aim of this article is to keep us in the shallow end of the crypto whirlpool, so to speak. Actually, this article probably puts us in the kiddie pool…with floaties on. The point is, if you’re new to crypto, like me, this will be a good place to start.

What are Cryptocurrencies?

A cryptocurrency is a medium of exchange and/or a store of value that is digital, encrypted and decentralized. Basically, it can be used to pay for goods and services (where accepted), or it can be held for investment purposes. Unlike fiat currencies like the U.S. Dollar or the Euro, there is no central authority that manages and maintains the value of a cryptocurrency. This means it has no intermediaries when transactions are conducted. Crypto transactions are independent and peer-to-peer and are held as entries in a public ledger, such as a blockchain, that is collectively maintained by the participants on the shared network.

Most users of cryptocurrency utilize a type of software called a “digital wallet” to manage and secure their digital currencies. From these wallets, users can receive, hold and transfer cryptocurrencies. Digital wallets can run on personal computers, cell phones, secure hardware devices or can be hosted by third parties online.

For a quick tutorial on the process of buying cryptocurrency, check out this video.

How is Cryptocurrency Most Commonly Used?

Cryptocurrencies were initially intended to facilitate payments transactions. Given the significant price volatility, however, most companies have not adopted cryptocurrency as a valid form of payment for goods and services. In other words, crypto values are not yet stable enough to truly be thought of as currency. The current tax treatment in the United States, which I’ll touch on next, is also a barrier to the adoption of cryptocurrency as a “real” currency.

The most common use case for cryptocurrencies today is as an investment, or a store of value, to be liquidated into fiat currency sometime in the future. In this sense, we should think of cryptocurrencies as competing with commodities such as gold or silver, not as viable alternatives to “real” currencies such as the U.S. dollar.

What are the Tax Implications of Cryptocurrency?

The IRS treats cryptocurrency as property for federal tax purposes. Taxes on crypto transactions are essentially the same as the taxes you pay on any other gain realized on the sale or exchange of a capital asset. Crypto-related taxable events include the following:

Selling cryptocurrency for fiat currencies: e.g., selling Bitcoin for U.S. dollars.
Trading crypto for crypto: e.g., trading Bitcoin for Ethereum.
Spending cryptocurrency on goods or services: e.g., if you bought crypto for $3,000, which later increased in value to $7,000, and then you used it to purchase a motorcycle worth $7,000, you are taxed on capital gains of $4,000.
Receiving cryptocurrency as income in the form of wages or salary.

It’s also worth noting that cryptocurrency losses are tax-deductible. If you don’t have any capital gains to offset with crypto losses, you can deduct up to $3,000 per year from your ordinary income.

The tax consequences of crypto transactions are easy to overlook, but the IRS has been cracking down on unreported transactions in recent years. In 2019, for example, the agency sent letters to more than 10,000 taxpayers who engaged in taxable virtual currency transactions, requiring them to pay back taxes and file amended returns.

How Does the IRS Know About My Crypto Transactions?

A little-known fact is that crypto exchanges, such as Coinbase, Kraken, Binance.us, Gemini and Uphold, report user transactions to the IRS. During any tax year, if you received proceeds of more than $20,000 through a crypto exchange, you will get a Form 1099-K indicating proceeds you received each month during that year – if you do receive such a form from a crypto exchange, the IRS also knows that you have reportable cryptocurrency transactions.

How is Cryptocurrency Valued?

Cryptocurrency values are generally determined by classic supply and demand dynamics. As demand for crypto rises, so too does the price. Increased demand can come from seasoned investors or from first-time speculators just dipping their toes in the market. Conversely, the price goes down as demand for crypto goes down. This happens when more investors are trying to sell their positions than are trying to buy. This can have a domino effect, as investors who would not otherwise be interested in selling decide to offload their holdings before prices fall further and all profits are lost. To be clear, this domino effect can run in either direction, up or down, and it typically moves very quickly. For example, Bitcoin was valued at about $65,000 per “coin” in April 2021. By July 2021, the price had fallen to around $29,000, and it’s currently back up to around $51,000 per coin (as of September 2021).

As of September 17, 2021, the total global market cap for crypto assets was $2.13 trillion across roughly 12,000 different cryptos. That is a staggering amount of action for a market that most people seem to know very little about. According to a recent survey, “33.5% of crypto investors have either zero knowledge about the space or would call their level of understanding ‘emerging’, while only 16.9% of investors ‘fully understand’ the value and potential of cryptocurrency.” As British online newspaper, The Independent, recently put it, “A third of cryptocurrency investors don’t know what they’re doing”.

This reminds me a bit of the Great Toilet Paper Crisis of 2020 back at the beginning of the coronavirus pandemic. Stay with me here. Recall that everybody was buying up massive stocks of toilet paper for their homes, and nobody really knew why they were doing it. They just knew that everybody else was doing it, so they thought they should probably do it, too. This same “fear of missing out” type of behavior is likely a significant driver of crypto purchases and ultimately prices in recent years as a result.

On the other hand, another survey conducted in April 2021 found that Americans who own cryptocurrency hold an average of only $1,003 in crypto. This suggests that while many investors know little about crypto, they are at least wise enough not to put significant dollars at risk. In other words, a majority of new crypto investors are likely just curious about the products and are buying small amounts just to see what happens. Will they stick around for the long haul? And what does the answer to that question mean for long-term valuations?

From a market share perspective, the crypto space is dominated by just two cryptocurrencies. As of September 17, 2021, Bitcoin represents $894 billion, or 42%, of the entire market, while Ethereum boasts a market cap of $406 billion, representing 20% of the global crypto market. The next largest share of crypto is held by Cardano at only 4%.

I Hold Cryptocurrency in My Business. How Should I Record These Assets?

Currently, there is no formal accounting guidance for digital assets under U.S. generally accepted accounting principles, or GAAP. However, in December 2019 the American Institute of CPAs issued non-binding guidance indicating that cryptocurrencies should be accounted for as intangible assets, in accordance with ASC 350, Intangibles–Goodwill and Other.

Essentially, this means the value of cryptocurrency is recorded as an asset on the balance sheet at cost. It stays there at the same amount unless its value declines. If a company sees signs that the value has weakened, the company must record an impairment, which hits the income statement as a charge to earnings. The company must test the crypto asset for impairment at least once a year, but more often if there are indications that the value is lower.

For a real-world example of accounting treatment and related disclosures for cryptocurrencies, see Tesla, Inc.’s most recent 10-K filing here (search for keyword “Bitcoin”).

Regulatory Interest

Banking regulators have also started taking the continued emergence of digital assets more seriously. Beginning with Interpretive Letter 1170, the OCC has issued a number of letters on crypto-related matters such as custodial services for crypto assets and participation in independent node verification networks. The FDIC also put out a Request for Information and Comment on Digital Assets in May 2021.

Want to learn more about cryptocurrencies?

Join us for a cryptocurrency webinar on Thursday, October 28th from 2:00-3:00 p.m. (CST)/3:00-4:00 PM (EST) presented by our Financial Institution Advisory Group!

Questions?

For more information about potential crypto-related impacts to the financial services industry and the evolving regulatory environment, please contact our resident experts, Paul Allen and Kristen Stogniew.

For additional crypto insights from an asset management perspective, please reach out to our expert advisors, Christina Doss and Chris Stennett.

For additional crypto insights from a taxation perspective, please contact our expert advisor, Suzanne Cox.