With the explosion in the usage of various cryptocurrencies lately, it’s becoming more and more important to understand exactly how they work and how they are being used. While it’s common to assume that a cryptocurrency can be treated just like any other type of currency, the truth is a bit more complicated, and it can have significant tax-related ramifications for anyone who uses them or accepts them as payment.

What Is Cryptocurrency?

There are several types of cryptocurrency available, with the most popular being Bitcoin. Alternative varieties include Litecoin, Etherium, Zcash, Dash, and Ripple, among others. All of these operate within the same type of basic framework that relies on cryptography to verify transactions. This ensures that the same units of currency can’t be spent multiple times, thereby establishing the value of that currency.

That value can fluctuate, however, in a manner similar to that of a traditional currency but much more dramatically. That’s partly because there is a limit to the number of units of each currency that can be in circulation. So the more people who are holding these units, and the closer the number in circulation gets to the cap, the more valuable each unit becomes.

Of course, there are a number of other factors that go into determining the value of any given cryptocurrency at a given point in time, but the basic structure for each is the same. There had been several previous attempts to create a virtual currency, but all had failed due in large part to their reliance on a company or other large entity to serve as a guarantor of the transactions. The cryptographic model eliminated the need for that guarantor, and so Bitcoin was able to flourish.

Uses and Trends

Cryptocurrency can be used to make purchases, or it may be acquired as an investment. Although the number and types of places you could use cryptocurrency were limited at first, there are even apps now that make it possible to pay in cryptocurrency at a brick-and-mortar store. Investing in cryptocurrency is another common practice, made more attractive by the dramatic spike in the value of Bitcoin in particular recently.

In October of 2013, one Bitcoin was worth about $150, and it increased shortly thereafter to almost $1,000. The value then hovered in the hundreds of dollars for the next couple of years before suddenly rising dramatically, spiking at close to $20,000 in December of 2017. Since then, Bitcoin has settled back down, with a value as of this writing around $8,000 per unit (you can check the current value of Bitcoin and other cryptocurrencies here). That demonstrated volatility has made it and other cryptocurrencies look like attractive investments to some, despite the potential for incurring large losses as well.

Cryptocurrency and Taxes

Another aspect of dealing in cryptocurrency that many people are not aware of before investing in it is the fact that, for tax purposes, the US government considers cryptocurrency to be property rather than currency. This may seem like an insignificant distinction, but it actually has a direct and dramatic impact on the tax bill you may receive if you’ve been using cryptocurrency.

That’s because, when cryptocurrency is viewed as property, making a purchase with it actually becomes two transactions. The first involves converting the cryptocurrency to traditional currency, and the second involves completing the purchase with the traditional currency. These are steps you may not be aware you are taking, but as far as the IRS is concerned, they occurred. Thus, you are responsible for paying capital gains tax on the first transaction and possibly sales tax on the second, depending on the item purchased.

Investing in cryptocurrency is risky as well, especially if you only plan on holding it for a short period of time. Any cryptocurrency you sell after holding it for less than a year will cause your profits to be taxed as income. If you do hold the cryptocurrency for more than a year before selling it, your profits will be considered long-term capital gains, and so be taxed at a lower but still significant rate.

This is a dramatically different process than that involved in converting between traditional currencies, and due to the volatile nature of cryptocurrency value, it’s very possible for you to wind up with a tax bill that’s much higher than the current value of the currency you’re holding. Similarly, converting from one cryptocurrency to another is two transactions rather than one for tax purposes, leading to the same types of potential pitfalls and high tax bills as using cryptocurrency to purchase goods.

The popularity and versatility of cryptocurrency mean that it’s likely not going away any time soon. That makes it an essential element to understand, both as a consumer and as a retailer, and while it’s possible to deal in cryptocurrency profitably, it’s important to know exactly what you’re working with so that you’re not overwhelmed when your tax bill arrives.

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