Everyone is talking about “crypto” these days. We hear terms being tossed around such as “digital assets,” “tokens,” “wallets,” “keys,” and “blockchain.” Many of us are investing in cryptocurrency and NFTs (non-fungible tokens) yet have never given a thought to what will happen to those assets if we die or become incapacitated.1 This is a two-part newsletter. Part One is directed at those of us who need a better understanding of the universe of crypto. Part Two will address estate planning for crypto.
What are crypto-assets?
There are no universally accepted definitions for the terms used in “crypto.” One commentator has suggested defining “digital assets” as those held on a computer system and composed of numerical values, and which are self-contained, uniquely identifiable, and possessing a value.2 A crypto asset is a digital asset that is secured by cryptography, rather than held, managed, or secured by a third party (such as a bank or investment firm). The word “crypto” derives from the encryption algorithms and other cryptographic techniques used to ensure security of assets held outside of these traditional locations. Crypto-assets are secured via “blockchain.”
What is “blockchain”?
The way blockchain works is that digital information is recorded and stored in blocks. Once a block is filled, it is closed and linked to the preceding block in its chain. Each block is given an exact timestamp when it is added to the chain. The blocks are chained in chronological order. Blockchains can be stored in a decentralized way, meaning no single person or group has control of the block chain; all users collectively retain control. Because a blockchain is decentralized, the data is irreversible… it can’t be altered, deleted, or destroyed. Transactions stored on blockchain are trackable. Every detail regarding cryptocurrency transactions is in the public domain thanks to the presence of a decentralized ledger that records all the blockchain details.
What is a key?
Transfers of crypto-assets take place via private and public “keys.” Because these assets are intangible digital assets, and do not have a central repository, access is only available to the holder of a private key. A key consists of a unique digital code. No third party holds the asset so no one can be compelled to produce it. There is no way to change or “reset” the private key. The holder of the private key has the absolute ability to transfer control or ownership of the digital asset, but if the controlling keys are lost, the asset is lost. Both the public and private key are required.
Where do the keys come from and what is a wallet?
Crypto keys are generated by a “wallet.” A wallet is comparable to a keychain. It holds all of your keys. Crypto wallets are an essential tool for buying, trading, and selling cryptocurrencies. They allow you to store the unique digital codes you need to transfer the assets and enable you to protect and validate transaction information. The actual asset is not stored in the wallet; wallets interact with the blockchain, allowing the owner to access the blockchain network and transaction history. The wallet generates the codes for the crypto asset. A multi-token wallet can hold many kinds of crypto-assets.
You can have a wallet on your phone, laptop, desktop, or special purpose device. There are both hardware wallets and software wallets. A hardware wallet is one that plugs into a USB drive and comes in physical form, like an external drive. If a hardware wallet is lost, the access is lost, and the device cannot be replaced. Nevertheless, hardware wallets offer better security for storage. Software wallets are more vulnerable to security breaches because they are connected to the internet. All kinds of wallets are available to purchase online. Investopedia reviews the wallets and recommends types of wallets for different types of investing.3
Wallets provide both private and public keys to enable users to interact with their digital assets. The public key is the wallet address used to receive funds; the private key is used to access your funds for transfer, sort of like a PIN code is needed to withdraw money from your bank account. The key resembles a QR code. It is actually a long string of characters. A private key is 256 bits long. The public address is also a very long digital code. You can back up your key on paper if you are afraid you will lose it. Do not give your key to your attorney; hold it in your safe deposit box.
What is an exchange?
Money and crypto-assets are transferred on exchanges. Exchanges are third parties using proprietary systems. Unfortunately, exchanges are frequently hacked, and assets are stolen. Some exchanges provide controls for access, such as multi-step sign-in. Some exchanges are insured.
Cryptocurrency and what is an NFT?
Cryptocurrency is a crypto asset that is treated within the crypto community as currency. In other words, it purports to be a form of money. However, the vast majority of countries refuse to recognize cryptocurrencies as money. The Internal Revenue Service categorizes cryptocurrency such as Bitcoin as an intangible item of property for income tax purposes. Because it is held for investment purposes, it is a capital asset. The rate of tax depends on the length of time the property is held and the tax bracket of the owner. Computing the basis of each asset in a series of crypto-to-crypto transactions, across exchanges and wallets, can be an enormous challenge. Also, crypto-assets can “airdrop,” meaning they can be sent free en masse to stimulate the market, or “fork” which means they change in value in a way comparable to a stock split.
NFT is an acronym for “non-fungible token.” Forbes and Investopedia define NFTs as crypto-assets that cannot be traded or exchanged at equivalency. In other words, unlike Bitcoin, or other cryptocurrencies, NFTs are not treated, even within the universe of crypto, as money. NFTs can consist of digital art, music, domain names, and more. One example of a popular NFT is “Crypto-Kitties.”
The federal regulatory agencies here in the U.S. including the SEC, the CFTC, and the Department of Labor, are jockeying for control over the regulation of crypto. A lack of regulation leaves investment in crypto highly vulnerable to fraud, market manipulation, theft, and other forms of consumer exploitation.
The IRS is increasingly aggressive with regard to cryptocurrencies, asserting that taxpayers are neglecting to report income and pay taxes on crypto transactions. With recent increases in IRS staffing and public declarations of the agency’s concerns over crypto, we anticipate that crypto ownership will be a red flag, triggering possible audits. The IRS now requires you to report on the first page of your tax return whether you invest in crypto.
What is mining?
Most of us do not have to worry about mining in crypto. Mining is the process of creating new cryptocurrency by solving puzzles. The mining process also confirms transactions on the cryptocurrency’s network. Issues as to whether compensation in the form of crypto constitutes ordinary income or a capital asset remain unresolved.
How to buy crypto
Investors can buy crypto from a broker or an exchange, or directly from another investor. If a company owns crypto, an investor can buy an interest in the company, and thereby own the crypto indirectly.
What are the risks of investing in crypto?
Investing in crypto is extremely risky.
- Not only can your investment lose value due to a loss of marketability, but the market for the crypto asset is highly likely to collapse completely, resulting in a total loss of investment.
- Crypto is poorly regulated, resulting in a loss of consumer protection. Highly vulnerable to market manipulation, such as “pump and dump” schemes, crypto is also used for money laundering.
- Because crypto is decentralized, no central authority controls transactions, so it may be impossible to file a transaction dispute. In peer-to-peer transactions, a seller may refuse to send tokens, or refuse to pay for an asset. Some platforms offer digital escrow services to mitigate these risks. On the other hand, other platforms have weak security or charge exorbitant commissions.
- Crypto is highly volatile, meaning the value can swing frequently and dramatically. In fact, chances are extremely high that you will experience a total loss of your investment.
- Control of the keys to crypto (and any other layered security measures) is control of the asset, itself. Giving someone the keys is tantamount to giving them a pile of cash.
- Crypto held in digital wallets and traded through digital exchanges is vulnerable to cyber theft and hacking.
- Private keys can be inadvertently lost or destroyed.
- Failure to report and recognize income can result in penalties and substantial interest charges imposed by the IRS.
The bottom line is this: only invest what you can easily afford to lose.
Part Two of this newsletter will discuss estate planning for crypto-assets.
1 I wish to acknowledge Pamela Morgan, Esq., an expert in this area of the law, whose book is available on Amazon, at the link below. Her webinar presentation inspired and informed my ideas. Cryptoasset Inheritance Planning: a simple guide for owners: Morgan, Pamela, Antonopoulos, Andreas M.: 9781947910119: Amazon.com: Books
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