Ever since Bitcoin was introduced in 2009, a lot of books, websites and courses have mushroomed on how cryptocurrency works for dummies.
Whether or not you want to invest, it never hurts to be informed. So let’s dive right into this piece on how cryptocurrency works for beginners. Know the benefits and risks of investing in crypto, as well as how you can manage taxes from crypto profits!
What is cryptocurrency? Do You Need to Pay a Bitcoin Tax?
Cryptocurrency is basically digital currency whose value falls and rises, just like rupees, dollars and other currencies issued by national governments, or as we call them, fiat currencies. In order to buy cryptocurrency, you need a wallet, meaning an online app to hold your currency. You can buy cryptocurrencies through an online exchange, a cryptocurrency ATM or from other people who own that currency. On the surface, it looks quite similar to fiat currencies.
But there are some key differences between cryptocurrencies and fiat currencies:
- First, cryptocurrencies don’t have notes and coins, it is all digital, and it is represented by pieces of code.
- Second, you don’t need a bank to make a transfer. There is a private key that allows you to send money to other people and authorize your transactions using your digital signature. There is a public key that allows you to receive payments from others. No middlemen are involved, and transactions are anonymous.
- Third, cryptocurrencies are not issued by the government or any other organization. They operate on a decentralized system.
If you’re mining crypto like Bitcoin and making a profit, you will need to pay taxes, but we will come to that a bit later.
What is a decentralized system?
Let’s say you sent some bitcoins to your friend. Your transaction will be broadcasted to all the computers in the bitcoin network. After every 10 minutes, all recent transactions will be grouped into a block. These blocks form a blockchain. Hence, the blockchain becomes a ledger where all cryptocurrency transactions are recorded.
The number of transactions that are recorded on this ledger every day is huge. As of today (May 2021), approximately 2,50,910 bitcoin transactions have taken place the day before. In this online ledger, we must make sure that all recorded transactions are verified. Enter crypto mining.
What is crypto mining?
Crypto miners run a race to solve extremely complicated computational math problems using specialized software. The first one to solve it gets rewarded in cryptocurrencies, and their ledger, or their version of the transactions, becomes the official one. So you can see here why it is called a decentralized system because there is no one person or device having control and authority over the process.
Pros and Cons of cryptocurrency
There is not one, but more than 6700 different cryptocurrencies on the market. Bitcoin is undoubtedly the most popular, along with other altcoins, i.e., alternatives to bitcoin like ethereum, Litecoin and the beloved dogecoin, which started as a joke and ended up crashing trading platforms. A lot of cryptocurrencies are improvements and modifications over features of the original bitcoin.
Let’s look at some advantages of investing in cryptocurrency:
- First, cryptocurrencies are more resistant to inflation, unlike fiat currencies. The value of cryptocurrency is not tethered to anything like employment, import-export, foreign exchange reserves, etc. So changes in these factors have no impact on the value of cryptocurrency.
- Second, they are portable.
- Third, they are infinitely divisible; you won’t be bugged by the problem of not having loose change.
- Fourth, crypto transactions are transparent. The blockchain operates on a peer-to-peer system and everything except the identity of buyers and sellers in public.
- Fifth, cryptocurrencies are universally acceptable.
- Finally, you don’t need any special permission, license or training to use cryptocurrency. You don’t even need to pay anyone to maintain your account and conduct your transactions.
However, every (bit)coin has two sides. Let’s look at some risks and problems involved in cryptocurrency:
- One problem with cryptocurrencies is volatility. The price of cryptocurrencies is very sensitive to speculation. While cryptocurrencies can be used to buy some products and services, most people buy cryptocurrencies in the hopes that they can exchange them for big money in the future. So any sniff of bad news, panic and fear can send the buy-sell cycle on a roller coaster ride. For example, according to the Bitcoin Volatility Index, as of a month from today (May 2021), the value of bitcoin is expected to rise by 4.66%.
- Secondly, blockchains are still in their infancy and are vulnerable to phishing (fraudulent messages convincing people to reveal sensitive information), hacking of wallets, hacking of login details of people working at cryptocurrency exchanges, and manipulation of digital signatures.
- Finally, you need to beware of cryptocurrency scams like pump and dump. These often involve crypto tokens. Tokens are cryptocurrencies that operate on existing blockchains. They attract investors to put money in and pump demand for currencies that are typically cheaper and less popular. After accumulating investors, the creators of these tokens sell them away, and the demand suddenly fizzles out.
Crypto Mining and Taxes: What You Need to Know
Now, investing in crypto might seem fun, but Bitcoin and Ethereum are subjected to capital gains tax rules. For one, all crypto-currency are treated as capital assets, and you owe the government a certain amount of tax when you sell it at a profit.
Bitcoin taxes depend on the location you’re in. For instance, Canada views Bitcoin as a commodity. So, it may be taxed either through income tax or capital gains tax.
Should your crypto profits be taxed as part of your income, you will pay income tax on the total proceeds of your transaction. The exact percentage of tax you will pay will depend on your income that year, and which tax bracket you will fall in.
The capital gain taxes, on the other hand, depends on how long you have a cryptocurrency and whether you have mined it as a hobby as an individual, or as a part of a business entity. How much you pay also depends on the jurisdiction you’re in.
In the U.S., if you have only involved yourself in less than twelve months, your profits are taxed at the rates of short-term capital gains, which is the same as your regular income tax rate. However, if you have been holding the Bitcoin for more than a year, you will be categorized into long-term capital gains, making your income tax lower than the former.
Canada, on the other hand, doesn’t have a specific capital gains tax rate. You don’t have a separate rate for short-term and long-term gains. So, your crypto gains get taxed at the same rate as your federal income tax rate and provincial income tax rate.
What about any losses in crypto?
Much like other investments, crypto also lets you claim a capital loss if you were unable to make any profits or sold at a loss.
When used with purchases, Bitcoin is also applicable to taxes, as it counts as the sale of the currency. On top of this, the purchase also requires you to pay sales tax.
With most miners, this is categorized as a part of your regular tax income. You are assigned to pay tax on the entire fair market value of Bitcoin or Ethereum on the day you received it, as per the regular income tax rate.
If you have earned profits while mining the currency, you also pay capital gain taxes on the profits, depending on the duration of your investments and the profit generated during the term. Considering the scenarios of unending taxes, you might want to consider keeping a record of all your transactions, so as to make things easy come tax time.
Do Tax Authorities Track Crypto?
Tax authorities like the CRA in Canada are working with crypto exchanges to track any crypto investments. Most crypto exchanges need your profile and ID when you sign up – and they can pass this on to government agencies when they ask for it.
Most crypto investors store their crypto in exchanges, rather than hard wallets, and it’s easier for government agencies to track any crypto movements.
Other Possible Tax Issues with Bitcoin Mining
Despite the tax rules, the regulatory policies still pose a challenge. Even Kazakhstan, the largest country of Bitcoin miners has assimilated new operational procedures to oversee the high demand of their power grids.
In the US, the federal government is aiming to get significant control of the platform by 2023 and has also urged the Federal Reserve to look into the risk factors underlying the booming business.
Climate change and reducing carbon footprint has taken precedence in recent years and it is needless to say that Bitcoins have been in the limelight. In response to the rising environmental concern, Tesla, one of the biggest Bitcoin investors recently announced that it would further suspend any purchase due to various environmental factors and its impact on fossil fuels. The company further announced that it will reinstate its purchase only with those working on renewable sources of energy.
The response from the crypto industry has been welcoming as well. Many of the long-running companies with large facilities have been transitioning to renewable sources.
Companies such as Lancium, and HIVE operate on 100% renewable sources of energy with high and efficient storage. As of now, over 40% of US companies have made the transition, with the rest still underway for the change.
By Soubhik Chakrabarti