When I meet with a potential new client, I always ask if they own any cryptocurrency. Why? Because cryptocurrency is recognized by the IRS as “property” and needs protection just like any other asset, belonging or possession.
Digital currency, like Bitcoin ($BTC), remains a popular investment option for millennials and a hot topic in today’s culture. Most discussions about Bitcoin involve how to acquire, use, trade or sell it. However, there are many Bitcoin holders who do not truly understand how it works, how to protect it, or the tax implications of each transaction. While some owners of digital currency may think the value of their holdings or transactions is too low to care about these things, upward spikes in cryptocurrency prices have been known to turn a small to modest size holding into big ole bags of money in a very short and unexpected period of time.
As the value of digital currency starts to steadily increase again, owners should take necessary steps to maximize protection of their virtual property and ensure their ability to leave it behind to whomever they choose. Equal consideration should been given to their beneficiaries, who should able to safely, securely and easily access these digital assets whenever and however the account holder decides.
Inventory your digital currency
The first step to protect your digital currency and other virtual assets is to include them in an estate inventory. Along with your other assets – such as real estate, personal property, bank accounts, retirement accounts, life insurance policies, stocks, bonds, and other investments – your digital currency is a piece of your overall estate and contributes to its ultimate value.
Therefore, if you hold Bitcoin or any other form of digital currency, it is strongly recommended that you work with an estate planning lawyer or other trusted advisor to privately, securely, and confidentially record pertinent information relating to you digital currency holdings. This information should be included in any designed estate plan so that, upon your incapacity or death, your lawyer can assist your agent, personal representative or trustee to access your digital currency and, when necessary, distribute it to your beneficiaries.
If not an estate planning lawyer or trusted advisor, then a digital currency owner should at least inform a trusted family member of such holdings. This way, in the event of the owner’s death, the family member will have knowledge as to the existence of a digital currency holding and can retain the services of a professional to assist in locating and recovering those digital assets.
Share your “private key” with someone you trust
Bitcoins are not accessible like cash in a bank account. You cannot enter a PIN into an ATM or fill out a withdrawal slip with a teller to access your funds. Similarly, your agent, personal representative or trustee cannot contact or submit paperwork to an online cryptocurrency exchange in order to gain access to your accounts.
In contrast, cryptocurrencies are accessed and exchanged only through the use of a virtual “wallet.” While an owner holds their wallet, the wallet does not actually hold any digital currency. Instead, a virtual wallet holds a “private key” that is unique to the wallet holder and allows the holder to access and use their digital currency in the proper online forum. As such, the only way for someone to access your Bitcoins is to have access to your private key.
Similar to a bank PIN, a private key is rarely ever shared, and for good reason. Bitcoin holders, during their lifetime, do not want to provide access to their private key because it may provide access to substantial amounts of money (depending on the daily rate of the digital currency being held). Unlike a bank PIN, a private key cannot be changed or replaced. Once a private key is lost, access to any Bitcoins associated with that private key is also lost.
Accordingly, it is strongly recommended that if a virtual wallet is stored on a trusted and secure online network (“hot wallet”) at least one back up the wallet should exist offline (called a “cold wallet”). A backup can be performed in various ways, including purchasing a designated backup digital wallet, using an external hard drive, or simply writing the private key code on a piece of paper and placing it in a safe deposit box.
A recent policy issued by the Office of Comptroller of Currency (OCC) states that national banks can now provide cryptocurrency custody services to their clients, including the holding of cryptographic keys. This is now another, possibly more trusted, alternative to safely and securely store a cold wallet.
Bitcoin transactions are taxable events
As mentioned above, the Internal Revenue Service (IRS) treats cryptocurrency as property rather than fiat currency, such as the US Dollar ($) or the Euro (€). This is important, specifically for federal tax purposes, because cryptocurrency is categorized as an intangible asset that is neither cash nor a financial asset. Depending on how it is held and used, digital currency can be classified as business property, investment property or personal property.
As a result of this treatment by the IRS, cryptocurrency owners must understand that a taxable transaction takes place every time digital currency is used for goods or services. Examples of taxable transactions include making purchases with digital currency, receiving digital currency for providing a service, trading Bitcoin for another cryptocurrency, and trading Bitcoin for fiat currency.
Because capital gains or losses are incurred every time cryptocurrency is sold, traded, or otherwise disposed of, it is important to keep track of all digital transactions and the asset’s basis at the time of its use or receipt.
How to mitigate gift taxes for cryptocurrency
If you are holding a substantial amount of digital currency, it would also be wise to understand the tax implications of gifting such assets, as well as the tax implications for the recipient.
According to the IRS, “a taxable gift is any property transferred for less than adequate and full consideration.” In the simplest terms, this means a “gift” is when you give someone something and do not receive anything in return and/or you received something in return which is less valuable than the property you gifted.
With federal gift taxes, only the gift giver is responsible to pay any taxes associated with the gift. However, a gift giver will not owe any federal gift taxes until they give away more than $11.58M in cash or assets during their lifetime. Even better, married individuals you can apply their spouse’s unused gift tax exemption amount for a possible $23.16M lifetime gift tax exemption.
While most people do not have that large an amount of assets to gift away, the lifetime exemption for federal gift taxes is not permanent and may decrease before you pass away. The current lifetime exemption is set to sunset on December 31, 2025 and starting on January 1, 2026 it will decrease to $5M adjusted for inflation. As such, it is best to ensure that your estate plan accounts for changes in federal law, so that you can avoid any possible decrease in the lifetime federal gift tax at the time of your death in the future.
Another important number to know is the annual exemption for federal gift taxes. Currently, for the calendar year of 2020, the annual gift tax exemption $15,000. This means that you can gift someone money or assets, tax free, so long as the total value of your gifts is $15,000 or less for the year. This limit applies each person to whom you want to make a gift. For example, you can give up to $15,000 in cash and assets to each of your three (3) children during the year 2020 and not pay any taxes on those gifts. Moreover, any gift amounts under the exemption limit will not count towards your lifetime exemption for federal gift taxes.
Similarly, if you transfer ownership of your cryptocurrency valued at $15,000 or less to another person, there would be no gift tax. In contrast, if you gift someone your digital currency valued at more than $15,000, this would subject you to gift taxes of 40% for any amount over $15,000. However, if you have not yet used your lifetime gift tax exemption, you can defer payment of an incurred annual gift tax.
Cryptocurrency receives a step-up, or step-down, in basis
Another tax consideration of owning cryptocurrency is how the transfer of these assets will effect your heirs. A lot of challenges accompany digital currency when being passed to an heir. However, at least one positive exists and that is the ability for your heirs to receive a step-up in basis to fair market value of your digital currency at the date of your death.
To illustrate, if you had bought one Bitcoin for $100 years ago and it is worth $20,000 at the date of your death, your beneficiary could receive a basis of $20,000 in the virtual asset, wiping out any taxes on the $19,900 gain. When your beneficiary sells their Bitcoin at a later date, for say $40,000, they would incur a taxable gain of only $20,000 ($40,000 – $20,000), rather than $39,900 ($40,000 – $100) had there been no step-up in basis available. If, however, the price of Bitcoin drops to less than $20,000 after your beneficiary inherits it, a capital loss can be deducted (up to a certain limit) and any excess may be carried over for future tax year deductions.
On the flip side, if the value of Bitcoin declines since the date of purchase, the cost basis for a beneficiary is lowered at the date of the Bitcoin holder’s death. When the beneficiary cashes out the digital currency, more tax will be owed since the cost basis is lower. For example, if the deceased bought a bitcoin for $1,000 and the price fell to $700 on the date of death, the cost basis for the deceased’s beneficiary is $700. If the beneficiary then later spends the Bitcoin when the price is back up to $1,000, the beneficiary will be taxed on the $300 gain.
Based on the foregoing, if you own digital currency that has appreciated in value since the time it was purchased, it may be wise to hold on to those virtual assets as long as possible so your heirs can take advantage of the step-up in basis upon your death. Contrarily, if the value of your digital currency has significantly depreciated since the time it was purchased, it may be wise to spend or trade it so that you can take on the taxable loss (and seek a tax deduction) rather than leaving your heirs with a step-down basis on the virtual assets they inherit from you at your death.
Consider insurance for your digital currency
Insuring your digital currency is relatively new concept, but something to consider if you own or plan to own a large amount of cryptocurrency in the future.
Currently, there are only a handful of companies willing to take the risk of providing insurance for digital currency, and the regulations and coverages are still not fully realized or defined. Most of the current policies in existence are written for individuals or companies that own and manage hot and cold wallets, such as a cryptocurrency exchange. In fact, very few policies are available for the cryptocurrency owners themselves.
Crypto-insurance will continue to emerge and progress as the value of Bitcoin and other digital currency rises, and will provide another level of protection of your holdings.
Do not do nothing
Failure to both protect your virtual assets while you are living and plan for the transfer of them at the time of your incapacity or death can have devastating consequences. Depending on the amount of digital currency in your portfolio, your loss may be in the millions of dollars that could have been passed on to your loved ones.
No matter how you save your virtual wallet and private key, smart estate planning includes providing someone with your private key information AND a means to access your private key, as this exchange of information is crucial in preserving your digital assets for your beneficiaries. Moreover, you should always take in to consideration the tax implications of each virtual transaction, and any digital currency gift.
Cryptocurrency is still extremely volatile and should be approached with caution, especially if you are a newcomer. Acquiring, holding, and exchanging Bitcoin and other digital currency can also become quite confusing, especially as it relates to estate planning. If you hold any form of cryptocurrency, schedule a no-cost consultation with me to discuss how you and I will design a plan that will allow you to protect and preserve your digital assets.