Pragmatic Realities of Bitcoin and Crypto-Investing

In Brief

Although many investors in cryptocurrencies like Bitcoin have witnessed great gains in the past year, values have also fluctuated dramatically in short order. Whether Bitcoin and other virtual currencies can retain their value over time is yet to be seen, but new IRS requirements entail increased disclosures. CPAs are likely to field complex questions from individual investors, and they should advise caution and be wary of providing investment advice in this risky field.

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Although many investors in Bitcoin and other virtual currencies have seen substantial returns in 2020 and 2021, the reality is that with greater returns come greater risks. In April 2021, virtual currencies reached a total market capitalization of over $2 tribllion, of which Bitcoin made up over $1 trillion. In comparison, the total market capitalization of Apple was over $2 trillion, and gold was around $10 trillion in April 2021.

Virtual currencies (digital, cryptocurrencies) have many known and unknown risks. Their value is of a perceived intangible nature, subject to extreme price volatility, lacking any governmental support, and generally not backed by any underlying assets. Whether virtual currencies can retain their value over time is an open question. These investments could easily become worthless overnight through possible governmental crackdowns and systemwide hacks—or they could increase substantially in value over time.

CPAs will be answering more clients’ questions on virtual currencies given their recent growth and new IRS reporting requirements. For tax year 2020, the IRS asked taxpayers on page 1 of Form 1040: “At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”

This article examines the recent surge in virtual currencies’ prices and popularity (with a focus on Bitcoin), the new IRS reporting requirements, and the inherent risks and return opportunities. This article, however, is not intended to provide investment or tax advice; simply, it depicts the pragmatic realities of the current landscape of cryptocurrencies. While there are more than 4,000 cryptocurrencies, Bitcoin is a good proxy for this relatively new asset class, as it is the largest (and likely oldest) virtual currency. It has seen significant price volatility throughout its history (see Exhibit 1). Bitcoin soared to around $64,000 on April 14, 2021, only to quickly drop almost 40% (sold on May 30 for around $37,000). Those who invested in Bitcoin at the end of 2019 saw significant appreciation in 2020 of over 300% in value (it closed around $7,200 on Dec. 30, 2019).

Investors Beware

The authors are not in any way advocating for or against virtual currencies as an investment; instead, we are informing CPAs on the current investing environment and the material risks of this relatively new asset class. We highlight what investors should consider before deciding whether to invest in these virtual currencies, which have seen significant interest and growth in 2020 and 2021. No one, not even advocates of cryptocurrencies, should underestimate the risks of virtual currencies: They have seen exponential growth, almost overnight, while mostly lacking any regulatory control or oversight by international governments.

Extreme caution is advisable for those invested, or contemplating investing. This is highlighted by XRP Ripple, once the third largest cryptocurrency. SEC litigation over its registration saw it trading at $.23 a share in January 2021; previously, it was trading above $.60 in November 2020, a decline of over 50% (Wall Street Journal, Jan. 4, 2021).

Article Data Sources

In 2020 and 2021, the international and U.S. press has focused a great deal on Bitcoin and other virtual currencies. The sources for this article are found in the Sidebar, “For More Information.”

Bitcoin’s and other virtual currencies’ pricing and data are to a degree problematic as they trade on hundreds of exchanges with no common definitive price. This lack of standardized industry pricing is not typical of a major publicly traded asset class, such as equities. An important reporting complication is that Bitcoin trades 24 hours a day, 365 days a year, with different prices reported based on the source consulted. The authors mainly utilized the Wall Street Journal, Barron’s, and Yahoo Finance cryptocurrencies database for the prices quoted in this article. As of early January 2021, the total value of all virtual currencies was roughly $1 trillion; Bitcoin made up $700 billion of this (Wall Street Journal, Jan. 7, 2021). This quickly rose to $2 trillion in April 2021, but then pulled back about 50%. The S&P Dow Jones Indices plan a new Bitcoin index in 2021, which should help pricing and market efficiency.

Virtual Currencies

While the focus of this article is on Bitcoin, there are many other major virtual currencies. Exhibit 2 lists the top ten cryptocurrencies based on market capitalization, per Yahoo Finance (June 2, 2021). While Yahoo’s database tracks over 100 different cryptocurrencies, there are over 4,000 cryptocurrencies internationally. While Bitcoin is the best known, many of the others are known as “meme coins.” The value of Dogecoin, a cryptocurrency that started as a joke in 2013, has risen 8,500% in value at the beginning of 2021 and is now reported at over $50 billion, more than Ford Motor Company (The Times of London, May 17, 2021).

This increasing popular sentiment and the risks of virtual currencies are clearly present with Dogecoin. When Elon Musk hosted Saturday Night Live on May 8, 2021, many expected him to continue his touting of virtual currencies, but instead he ‘jokingly” commented about Dogecoin that, “it’s a hustle.” In Sunday morning trading after the show, Dogecoin initially lost 36% of its value (Barron’s, May 9, 2021). Since then, Musk has continued touting virtual currencies (often through tweets), along with occasional negative comments (e.g., concerns over environmental impacts). Exhibit 3 shows the price volatility of Dogecoin at the beginning of 2021.

Bitcoin and most other digital currencies are generally based on the underlying technology Blockchain, which Fidelity Investments describes as follows:

Fidelity’s “Digital Assets Glossary” is helpful when researching this area. For example, one characteristic of virtual currencies is that they can be subjected to forks. According to Fidelity:

Forks, which can be implemented based on users’ changes, highlight another risk of virtual currencies, in that they are often not subject to direct regulatory oversight.

“Stable coins” are another virtual currency option. They are marketed as being backed by underlying assets (per se, the U.S. dollar). On February 23, 2021, however, the New York Attorney General’s Office asserted that “Tether’s claims that its virtual currency was fully backed by U.S. dollars at all times was a lie” (https://on.ny.gov/3zzkC8r).

Enhanced IRS Scrutiny of Bitcoin

As predicted in Mordecai Lerer’s January 2019 CPA Journal article (“The Taxation of Cryptocurrency,” https://bit.ly/3pSN8NB), the IRS is aggressively examining cryptocurrency transactions. The face of the 2020 1040 now requires taxpayers to indicate yes or no if they held any virtual currencies.

Taxpayers that sell virtual currency will face capital gains and loss rules because virtual currencies are treated as property. Various problems are likely, including individual specification (this easily occurs with a stock trade), as well as the applicability of the Net Investment Income Tax and possibly Self-Employment Tax. Since the IRS issued Notice 2014-21 (2014-16 IRB 938), it has expanded guidance under “Frequently Asked Questions on Virtual Currency Transactions” (https://bit.ly/3voD943). Question 39 addresses unit identification:

A possible tax planning opportunity is present because crypto is treated as property rather than a security, thus “wash sale” rules may not apply. This loophole would not apply to securities that are based on virtual currencies (CNBC, May 25, 2021).

History of Bitcoin

Bitcoin is the first and largest cryptocurrency. Bitcoin was created by an anonymous software developer known by the pseudonym Satasho Nakamoto; it was introduced during the 2008 global financial crisis for the purpose of buying goods, services, and currencies online. Bitcoins are “mined” globally by individuals using their computers to solve complex math problems. The feature that no single authority controls Bitcoin is a valued feature by some, but is a concern to many.

Blockchain’s open ledger program underpins most virtual currencies, including Bitcoin. The ledger is maintained among a network of interlinked computers wherein no one person can control or manipulate Bitcoin. The advantages of the scheme include the inability for governmental manipulation of price and risk mitigation relating to third-party fraud (Wall Street Journal, Dec. 7, 2017). Reportedly, 18.5 million out of a maximum potential 21 million Bitcoin coins have been created (Wall Street Journal, Nov. 30, 2020). The limited number of total Bitcoins is touted by some as a way to preclude inflation.

Investors cannot easily invest in Bitcoin directly, although the Chicago Board Options Exchange (CBOE) and CME Group offer retail customers the ability to trade in Bitcoin futures. According to Fidelity, the following are the risks of virtual currencies:

• Extreme price fluctuations
• Not legal tender
• There is no Federal Deposit Insurance Corporation (FDIC) insurance and platforms are not regulated
• Platforms can be hacked and have failed
• Subject to theft and fraud through illegitimate Bitcoin intermediaries
• Bitcoin payment is irreversible

The following are the opportunities of blockchain:

• It is a developing technology that could alter financial markets in a similar fashion as the Internet did
• It could be integral to emerging technologies
• It could provide greater control of financial data (https://bit.ly/3pSvDwS).

The SEC, in a 2014 Investor Alert, saw similar risks in virtual currency investments, as Fidelity noted in 2020. The SEC’s regulatory challenges included the tracing of money flows, international risks, the lack of a central authority, and the inability to seize funds. The SEC saw the following risks for investors: virtual currencies are not insured, have a history of volatility, could be subject to government regulations (including governments restricting their use), present security concerns (fraud, technical glitches, hackers, malware), and have no established track record. Over the years, around 20 cryptocurrencies have come under SEC scrutiny (Wall Street Journal, Nov. 26, 2019); many times, investors have not been made whole.

International Concerns

In 2013, China banned its banks from dealing in Bitcoin. The Peoples Bank of China (PBOC), the country’s central bank, announced that the Bitcoin prohibition was intended “to protect the interests of the public, to protect the legal status of the yuan currency [and] to prevent money laundering risks.” Furthermore, the PBOC cited concerns that consumers likely do not understand the risk of trading in Bitcoins, which it officially states is not a currency (The Times of London, Dec. 6, 2013).

In 2017, the Chinese government went further with the clamp-down on Bitcoin when it banned cryptocurrency exchanges and initial coin offerings (ICO). At that time, it was estimated that over 80% of cryptocurrency activity was tied to the Chinese yuan currency. The ban was prompted by concerns regarding investment risks and the prevalence of clandestine cash flows underlying many cryptocurrency transactions. China has since banned both domestic and foreign websites that promote crypto-currency trading (Wall Street Journal, Aug. 4, 2018).

In May 2021, China imposed further restrictions on cryptocurrencies. These new measures represent an expansion of previous crackdowns introduced in 2017. Beijing’s basis for the restrictions is premised on the notion that “virtual currencies are not supported by any real value” (Reuters, May 19, 2021). Environmental concerns relating to the energy consumption needed for crypto-currency mining was also a motive for the restrictions.

China’s new restrictions ban banks and other online payment vendors from offering cryptocurrency related services including account openings, trading, clearing, settlement, and insurance. These restrictions are largely a reiteration of the 2017 ban. In addition, financial institutions are banned from accepting cryptocurrencies and not allowed to utilize them in their transactions.

U.S. Government Cryptocurrency and Ransom-ware Concerns

As of this writing, the U.S. government has expressed concerns about the use of cryptocurrencies as a vehicle for perpetuating ransomware demands relating to cyberattacks against its institutions and private industry. White House officials are actively looking into identification of better ways to trace ransomware payments made with cryptocurrency (Wall Street Journal, June 3, 2021). These ransomware attacks are often of unknown origin and may involve state and nonstate players.

In a June 3, 2021 NBC News interview, Christopher Krebs, former director of the U.S. Cybersecurity and Infrastructure Security Agency (CISA), discussed the role of cryptocurrency in recent domestic cyberattacks resulting in significant civil disruption. Krebs stated:

Any regulation or restriction by the United States could have an impact on cryptocurrency investments globally.

Investing in Bitcoin and Crypto

The unique nature of Bitcoin and other virtual currencies makes investing in them directly somewhat complicated. An investor cannot simply purchase shares in an exchange traded fund (ETF) or buy them directly through many brokerage firms. Despite numerous applications, the SEC has not approved an ETF based on virtual currencies to date (Bloomberg, December 30, 2020).

While some are hopeful that the Biden administration will reassess this, former Federal Reserve Chairwoman and current Secretary of the Treasury Janet Yellen does not seem favorably disposed on the topic, as noted in the following:

For a 2% annual fee, an investor can utilize Grayscale Investment Trust (https://bit.ly/3iI4D1I) to invest in Bitcoin. In early January 2021, it was closed to new investments, but reopens periodically. Grayscale’s risk statement, posted on the frequently asked questions section of its website, notes the speculative nature of digital assets and their extreme volatility (https://grayscale.co/faq/). In the 2018 Annual Report for the Grayscale Bitcoin Trust, under risks it lists “changing governmental regulatory rules.” The Bitwise 10 Crypto Index Fund (https://bit.ly/3wBGz4w). another investment option, “seeks to track an Index comprised of the 10 most highly valued cryptocurrencies.” This trust has a 2.5% expense ratio. In March 2021, Fidelity applied to the SEC to create a Bitcoin ETF.

If an investor wanted to invest directly into Bitcoin or another cryptocurrency, they would need to establish a digital wallet and an account with an online exchange (per se Coinbase); there are hundreds of exchanges of various natures (including informal bulletin boards). Bitcoin can be divided down to eight decimals, so one can buy less than a whole coin. Extreme caution is advised, as phishing and hacking scams can and have occurred (Wall Street Journal, Dec. 7, 2017).

Cashing in on Bitcoin Investments

Those fortunate to own Bitcoin in 2020 and the beginning of 2021 need to be cognizant that its value has fluctuated extremely since it was introduced in 2008. As more international exchanges open, the use of leverage to make investments (or bets) on virtual currencies has increased. In 2017, Bitcoin surged to $19,000, to only lose half of its value in around a month. When China aggressively addressed cryptocurrencies in 2019, Bitcoin’s value fell to around $3,000.

While Bitcoin could easily lose its value in a dramatic fashion, it could also continue to surge. In early January 2021, a J.P. Morgan analyst predicted that Bitcoin could rise as high as $146,000 as it competes, albeit on a much smaller scale, with gold (CNBC, Jan. 5, 2021). This call is somewhat surprising, as in 2017 J.P. Morgan CEO Jamie Dimon, called Bitcoin a “fraud” stating: “It’s worse than tulip bulbs. It won’t end well. Someone is going to get killed” (CNBC, December 20, 2019). In 2018, however, Dimon stated he regretted calling Bitcoin a fraud (Wall Street Journal, Jan. 9, 2018).

Is Bitcoin Really a Currency?

Strictly speaking, Bitcoin and other cryptocurrencies are not a currency in the sense of being a medium of exchange in circulation that is generally accepted and prevalent (see the Sidebar, “Bitcoin is Not Money”). But they are accepted as a means of wealth transfer by a growing number of entities. Growing numbers of third-party vendors conduct retail Bitcoin and crypto-currency transactions for a fee (Square Inc.’s Cash App, Robinhood, and PayPal Holdings). The CME Group and Intercontinental Exchange offer derivative markets, and Fidelity Investments has a digital asset group for investors (Wall Street Journal, Nov. 30, 2020).

Bitcoin cannot be readily utilized to conduct smaller transactions. When U.S. taxpayers conduct Bitcoin transactions, the IRS treats these as property transactions that will cause capital gains and losses on each use. Services including BitPay and now even PayPal, however, will convert Bitcoins to dollars for a fee (this works better for higher dollar amounts). In addition, if Bitcoin systems were hacked, investors would likely face a dramatic and possibly even complete loss in value overnight with no governmental or private party insurance. China is experimenting with a digital currency with no transaction fees that does not require an internet connection, as transactions can occur through cellphones (Wall Street Journal, Dec. 27, 2020).

There have been reports over the years of investors that have lost the passwords to their Bitcoin holdings (a complex securities code), and there is no central authority or official for such investors to turn to. In 2017, it was estimated that around 3 million Bitcoins were lost (at the time, this represented about 23% of its total value). It was reported that even Elon Musk had lost part of his code (Wall Street Journal, Dec. 19, 2017).

Is Bitcoin Digital Gold?

Many compare Bitcoin to a gold investment. Unlike Bitcoin, gold has a unique tangible physical presence and has been a means of wealth storage for centuries; Bitcoin has been around for less than two decades. Gold has other uses (jewelry, electronics, medicines), whereas Bitcoin does not. Cryptocurrencies still represent a fraction of gold’s total value. Some contend Bitcoin is “gold 2.0 since governments can’t control and debase it. That’s why, like gold, some people view Bitcoin as a hedge against inflation” (Wall Street Journal, Dec. 7, 2017). As seen with China, in 2017 and 2021, however, governments can negatively impact the perceived value of a digital currency overnight.

Inherent Risk

The fluctuation of Bitcoin and other virtual currencies’ prices in 2020 and 2021 underscore their volatility and opportunity for abnormal profits and inherently substantial risks. Taxpayers are required to report their taxable virtual currency transactions to the IRS, even if they simply hold these assets, as of the 2020 tax year. When CPAs discuss these transactions with individual investors, it is important not to cross the line into giving investment recommendations. The emphasis needs to be on risks, known and unknown, the enhanced IRS reporting requirements, and conducting due diligence before making new investments.

As seen since Bitcoin’s inception in 2008, it is subject to extreme price valuations; other virtual currencies have seen this as well. Virtual currencies’ underlying risks since their inception remain prevalent and unresolved, with little recourse for investors who have no central authority to turn to when problems arise. Rapid deterioration and recoveries of virtual currencies values occur often, but there is no guarantee that a recovery will always occur.