Cryptocurrency, also known as virtual or digital currency, has been the hot new topic since 2017. While you may have heard about it, you may not know exactly what it is or why everyone is going nuts over it. Most people who are currently investing in cryptocurrency believe that it’s the way of the future and are hoping to invest now before it takes off.
But is it a good idea to invest in cryptocurrency? After the failed dot-com boom, people are becoming rightly cautious of too-good-to-be-true investments that are supposedly “guaranteed” to take off any day now. In order to invest smartly you need to invest in something that produces value over time. Here’s what you should know before you consider buying cryptocurrency:
What Is Cryptocurrency?
Cryptocurrency is a digital form of currency that uses cryptography to make transactions secure and difficult to fake. While most transactions use central banking systems, a central authority does not control cryptocurrency. Every transaction is recorded on a public digital ledger called a blockchain; this helps to prevent government control and interference. This works similarly to credit, only an algorithm keeps ledgers and issues currency instead of your government or bank.
There are many different kinds of cryptocurrency, but one of the most popular is Bitcoin. Many companies also have their own currencies that can be traded for the good or service that the company provides.
What’s The Appeal?
Part of the appeal of cryptocurrency is the cryptography used to maintain the privacy of digital transactions. Cryptocurrency is pseudonymous rather than anonymous: your account and every transaction you make are connected to one or more specific keys or addresses rather than your real-world identity. All transactions are available to the public in the blockchain, but the owner of the cryptocurrency is not identifiable.
This privacy can be helpful as most people don’t want their information published on a public blockchain for their friends, family, business competitors, or government to see. Cryptocurrency keeps your online data safe and, unlike physical money, doesn’t leave a paper trail.
Another part of the appeal is the idea that Bitcoin is the currency of the future. This belief has led supporters to buy them as quickly as possible before they become more widespread and presumably grow in price.
How Do You Buy It?
You can buy cryptocurrency by registering for a “bitcoin wallet”, an online app that holds your cryptocurrency. After registering with your identity and bank information, you can transfer real money to purchase cryptocurrency. You could also purchase a bitcoin exchange-traded fund (ETF), or a fund that holds bitcoin. This would be an investment and would allow you to access the currency and trade through your existing broker. Another option is buying and selling bitcoin futures, which would allow you to buy or sell bitcoin at a future date for a predetermined price.
In terms of legality, cryptocurrencies are legal in the U.S. but have been outlawed in China and certain other countries. While the SEC is increasing its regulation of coin offerings, there is still a lot of fraud out there from people seeking to make money off of the cryptocurrency craze, so exercise caution when purchasing digital currency.
Is It A Good Investment?
To invest in something is to put money into it with the expectation of it generating an income or profit. While cryptocurrencies may go up in value, they do not generate money in and of themselves. The only way to profit from cryptocurrency is to get someone else to pay more for it than you did. This is called “the greater fool” theory of investment, and is not as lucrative as investing in a well-managed business or stocks.
Part of what makes investing in cryptocurrency a risky idea is the volatility of the price of cryptocurrency. The extreme back and forth in the price of bitcoin makes it difficult to know when the best time to buy is. If most people are investing in bitcoin with the hope that they’ll one day increase in price, then they are less likely to spend and circulate them today. This makes them less viable as a currency and brings the value down.
A currency needs stability in order for buyers and sellers to determine a fair price for goods and services. If you were to buy a cup of coffee from your local coffee shop for $3 on a Monday only to find that Tuesday the price was brought up to $5 and again back down to $4 on a Wednesday, you’d never be able to reliably buy a cup of coffee from them and you’d probably never go there again. Instability in currency leads to instability in the market, and the instability of cryptocurrency makes investing in it less than ideal.
How Is It Taxed?
While the U.S. Government does not view cryptocurrency as money, this does not mean that trading in it will get you out of paying taxes for it. Crypto investors have faced fines and prison times for trying to dodge taxes on their use of cryptocurrency. Tax software has modules built for crypto investors to help account for cryptocurrency. There are also programs such as BitcoinTaxes and CryptoTrader that you can use to help document your crypto trades.
Reporting is up to you, so be sure to document everything. And note that anytime you sell cryptocurrency or use it to buy anything, you’ll be taxed. Money earned from selling cryptocurrency is taxable income. You’ll also need to keep track of several things, including the type of cryptocurrency you own, how you got it, and how you used it.
If you now how long you’ve owned it as well, this can help you when it comes time to pay taxes. Cryptocurrency held for under a year is taxed at short-term rates while over a year is taxed at long-term rates. Long-term rates are more favorable, so keep that in mind when trading.