Cryptocurrency has grown in popularity over the past few years. A few savvy investors who joined the Bitcoin bandwagon at the right time enjoyed handsome returns. Much as the potential to make massive gains on cryptocurrency investments is undoubtedly there, so is the risk of losses.
The value of Bitcoin and other digital currencies is still quite volatile, and unlike fiat currency, they are not backed by any precious commodity or regulated by any one government. The good news is there are ways to mitigate the risks.
Knowledge on Cryptocurrency
Many people are driven into crypto investments simply by the fear of missing out. You’ve heard so and so made a killing in just a few months, and you want to be the next success story. There’s nothing wrong with wanting in on investment with the potential for high returns. But you need to get your facts right before taking the plunge, as there is a lot of misinformation floating around.
The more optimistic crowd gets into crypto believing that a price spike, like the one Bitcoin saw in December 2017, is just around the corner. Others open digital wallets in the belief that crypto will soon replace conventional currency. Some believe that crypto is merely a vehicle for all sorts of illegal activity.
Getting a grasp of the basics of how crypto works can help to dispel many of the misconceptions surrounding it. Cryptocurrency, like ordinary currency, is a medium of exchange used to buy and sell goods and services in selected stores. However, as it is not issued or regulated by any one government, it is not legal tender.
Key to cryptocurrency’s operation is the blockchain—the public encrypted ledger in which cryptocurrency transactions are recorded. There are thousands of digital currencies already in existence, but Bitcoin, Ethereum, and Litecoin are among the more popular ones.
Tracking for Tax Purposes
One of the misconceptions about virtual currencies is that transactions involving them are not subject to tax because they are not centrally regulated. The truth is that cryptocurrencies have been on the Internal Revenue Service’s radar for some time. The authority published guidance on how cryptocurrency should be treated for tax purposes.
Therefore, you should keep a clear record of all your virtual currency transactions so that you file your returns accordingly. Whether you bought and sold crypto for speculation or received a donation in Bitcoin tokens, you need to keep a record of this.
Cryptocurrencies are very volatile in value. You can look at Bitcoin’s price history over the past three years to see this. The pioneer crypto opened 2017 at around $1,000 but closed the year at $20,089. Between then and June 2019, the price tumbled and then rose again to $10,000. But by December of the same year, the price plummeted to just over $7,000.
However, there was a resurgence as the world grappled with the pandemic. In November 2020, Bitcoin was trading at $18,353. Imagine your disappointment if you bought a couple of units and cashed out when the value dropped towards the end of 2019. If you’re buying into crypto as a speculator, it’s wise not to be in a hurry.
Hiring an Accountant
The IRS has taken a strong interest in cryptocurrency transactions. In 2014 the authority put out a bulletin detailing how it would treat virtual currency transactions entered into by individuals and businesses. To comply with these guidelines, you should carefully follow the bulletin contents and keep thorough records of all your digital currency dealings.
If you don’t have a financial accounting background, doing the above to the required standards will be a real challenge. You will be putting yourself at risk of missing out on a detail or two that could leave you facing hefty penalties. To avoid this, it’s wise to seek professional help for cryptocurrency accounting.
Using it to Pay Employees
Whether or not it’s legal to pay employees using cryptocurrencies is still a gray area. However, some states have laws that explicitly require employers to reimburse their workers in United States currency. But is paying employees in crypto a good idea?
It certainly will complicate matters as you are required to hold taxes in U.S. dollars. This means you have to convert the crypto to the dollar equivalent for your tax computations. Then there’s crypto’s volatility. What happens if the value of crypto plummets such that your employees’ wages are dragged below the minimum wage line?
Filing Taxes Incorrectly
You need to have a record of your cryptocurrency transactions and ensure you categorize them correctly. If you’re in crypto for investment purposes, you will be required to pay capital gains tax if you sell at a higher price than you bought. If you make money from crypto mining, you must file this as income which attracts income tax.
These are some of the tax filing intricacies the IRS explains in the IRB: 2014-16 bulletin. Without professional guidance, it’s easy to misfile your crypto transactions.
No Risk, No Reward
Cryptocurrency investment is not the only kind of investment that entails risk. Any investment avenue you can think of has an element of risk, and the more you risk, the higher the potential gains and losses. As with the other investment options, you can significantly mitigate your risks by researching and knowing exactly how it works.