Breaking the Code: Bitcoin Basics
By: Tyler Nguyen
This month, one of our interns, Tyler Nguyen, did a deep dive into a recent hot topic - Bitcoin.
What is Bitcoin? Bitcoin was the first type of cryptocurrency, developed in 2008 by an anonymous person. What makes Bitcoin and other cryptocurrencies so unique is that there is no centralized system (like banking) that may swap the supply or the valuation of the currency. One way Bitcoin in particular is not centralized is in its "blockchain" - a database that is not controlled by or stored on one particular system but is constantly added to in "blocks" during each transaction of Bitcoin.
Living up to its name, cryptocurrency uses algorithms / keys in order to keep track of transactions, to create new units (mining), and to keep the identity of the person using cryptocurrency anonymous.
Bitcoin has steadily started to gain more and more mainstream popularity in the past few years - a lot of that due to the speculation around it and its skyrocketing value. Many investors have high hopes for Bitcoin to increase further. Companies, including Tesla and Square, have recently disclosed that they are holding over $1 billion worth of Bitcoin. Tesla is even planning to accept Bitcoin as payment. Despite these advances, there are still barriers to navigate until Bitcoin is able to be widely used for purchases. Many Bitcoin transactions include converting Bitcoin to a fiat currency, which creates a burden on the companies that handle those transactions and causes fees to be high for the consumer.
How is Bitcoin stored? Bitcoin and other currencies have private keys associated with them that must be entered in order to access them. Individuals set up "wallets" that store these keys and allow the user to access their cryptocurrency (e.g. web wallets to access private keys to make transactions easier at the cost of security or USB drives that store the keys). Without the keys, it is impossible to use the cryptocurrency. If an individual were to lose the keys or if they cannot remember the password, they have no other way to retrieve their cryptocurrency.
Is Bitcoin taxed? On page 1 of the 2020 Individual Tax Return, the IRS has included a required question inquiring if taxpayers have received, sold, sent, exchanged, or acquired (any type of transaction) virtual currency in 2020. Cryptocurrency is treated as capital property, and the taxpayer has to pay capital gains tax when selling any form of cryptocurrency. Selling also includes any type of exchange of any cryptocurrency for goods or services (the taxpayer does not have to receive cash consideration for it to be considered taxable income). "Mining" cryptocurrency leads to cryptocurrency being recognized as ordinary income for the taxpayer. While becoming a more mainstream conversation, many don’t realize that these transactions are subject to taxation. Similar to traditional capital gains, it is very important to keep track of the basis in cryptocurrencies.
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