By the end of 2021, the overall market value of cryptocurrencies hit $3.3 trillion. Though cryptocurrencies have only been around for a decade or so, many investors are enjoying an exponential increase in value. As a result, investors have become more comfortable with tokens such as Bitcoins and networks like Ethereum and Solana. They enjoy the anonymity of owning and trading cryptocurrency, and the freedom from centralized control by banks and governments. Cryptocurrencies are assets that differ from traditional currencies in many ways. They tend to have more price volatility and, therefore, will require a somewhat different approach to estate management.
What is cryptocurrency?
A cryptocurrency is a digital asset that is created and traded online. It is a series of numbers, just like the serial numbers on traditional currency. The transaction is secured by cryptography or the use of encrypted algorithms and other techniques to safeguard the currency. Like traditional currencies, cryptocurrencies can be divided into smaller units. A wallet is where cryptocurrencies are stored. No personal information is needed to establish a cryptocurrency in a wallet.
A blockchain is a string of verified, public transaction records. It is like having a giant spreadsheet that is distributed across computers. Blockchains are decentralized networks across many computers that keep a ledger and oversee each transaction. The blockchain records are public and not issued by any centralized authority, but the identity of the person holding the cryptocurrency is anonymous. The transparency of the transactions is appealing for many investors as the system does not rely on trust to ensure transactions are completed. Transactions occur on exchanges such as Coinbase and Gemini.
Cryptocurrency allows transactions between peers and prevents double-spending by broadcasting each transaction across the network so every computer can check its records. Miners confirm transactions and allow them to pass through the network. Bitcoin mining is a process in which thousands of computers worldwide compete to record and verify transactions. The network pays them in bitcoin. The blockchain network is kept in consensus and secure using this monetary incentive.
Types of cryptocurrencies
There are thousands of cryptocurrencies that are coins or tokens. Coins are given to computers that process transactions.
Bitcoin, introduced by an anonymous person called Satoshi Nakamoto in 2008, is one of the most popular and valuable cryptocurrencies, since only 21 million Bitcoin will ever be produced. Other examples of cryptocurrencies include Ethereum, Dogecoin, and Tether.
Well-established networks are resistant to scams. For example, bitcoin has thousands of computers worldwide that would all need to be hacked simultaneously.
Tokens can be easily created. Non-fungible tokens are an example. Unfortunately, because they are easy to create, tokens can be scams.
What are non-fungible tokens?
Non-fungible tokens (NFTs) are digital assets that are unique and cannot be subdivided. NFTs can include assets, such as:
- A unique digital artwork
- A digital collection
- A domain name
- A tweet
- Sports collectibles
- Video clips
NFTs can be very expensive. Pak’s ‘The Merge’ sold to a group for $91.8 million and Beeples’ artwork sold for $69.3 million.
Some people purchase NFTs to own something unique, others to become part of a community. Any online asset can be an NFT and sold, even dividing a virtual map of all the locations on Earth into digital hexagons and selling each piece. Recording and tracking the sale on the blockchain ensures that it will remain an original and cannot be sold twice.
Cryptocurrency and Estate Planning
The Internal Revenue Service considers Bitcoin and other digital cash as property rather than currency. Therefore, any profits from purchasing cryptocurrency for personal or investment purposes will be subject to capital gains taxes. A determination of whether the capital gain is short-term or long-term depends on how long the cryptocurrency has been held. The threshold is twelve months. Miners, or people who are in the business of selling or creating cryptocurrency, are subject to ordinary income tax rates rather than capital gains rates.
A taxable event is triggered when a cryptocurrency holder trades the asset for fiat currency or a different cryptocurrency brand.
Important Estate Planning Considerations
The use of cryptocurrency has tax implications. Cryptocurrencies are volatile, and loss of value can be used to reduce tax bills. However, since the Tax Cuts and Jobs Act of 2017 was passed, cryptocurrency holders cannot use like-kind exchanges to defer capital gains taxes.
Cryptocurrency and the blockchain are new concepts for many people. Unfortunately, trading on newly established platforms that are open to hackers can lead to significant financial losses and increase the risk of being a scam victim.
Misplacing passwords or digital keys can result in significant financial losses. For example, one investor lost half a billion in bitcoin when they lost their private key. This is because cryptocurrency can only be accessed by having the public and private keys associated with the transaction. These keys are dozens of characters long.
The investment is lost when the wallet owner dies if the key is not shared with heirs. Therefore, estate planning documents should authorize a fiduciary to access their digital assets. For example, the estate plans we draft for clients have comprehensive provisions that authorize fiduciaries to access, control and manage digital assets.
The Future of Cryptocurrency
From governments worldwide and large tech executives to people living in developing countries who earn money playing blockchain-based games, the interest and potential applications for using cryptocurrency and the blockchain continue to grow. Therefore, it will be important for all users to understand techniques such as initial coin offerings (ICOs), like-kind exchanges, cryptocurrencies in foreign markets, and exiting large-gain positions. Estate planning for cryptocurrency assets involves new considerations, such as maintaining anonymity while ensuring valuable assets can be passed to beneficiaries.