Five years ago, cryptocurrency was probably not on your radar. Today, with one in five adults having invested in, traded, or used cryptocurrency, it may already be an important investment in your financial portfolio. You might even own some nonfungible tokens (NFTs), which are powered by the same blockchain-based technology. Despite the volatility in the value of these assets, you should ensure that they are included in your estate plan so you can preserve them for your heirs.
Preserving Cryptocurrency: Now and Later
Cryptocurrency is digital money in which transactions are verified and records maintained by a decentralized system using cryptography, rather than by a centralized authority. Although cryptocurrency is a relatively new asset class, with the first cryptocurrency, Bitcoin, emerging in 2008 as a direct response to the U.S. financial crisis caused by the banks and the government, cryptocurrency has exhibited remarkable growth and stability as part of the global financial landscape. Even though the value of individual coins (units of cryptocurrency) has been notoriously volatile, with the overall market rising from just under $148 billion in 2020 to $3 trillion in value in 2021, only to then lose $2 trillion in value in 2022, Bitcoin has been the best performing asset class of the decade. Given that Bitcoin and other cryptocurrencies are dependent only on the supply and demand in the market and are not subject to centralized bank or government control and manipulation, have publicly verifiable transactions and no third-party vendor to verify and validate transactions, and have a maximum limit to how much can be produced, it is no surprise that public trust and demand for cryptocurrencies is rising at a rapid pace and cryptocurrencies are likely to retain their status as a mainstream investment option.
A 2020 study by the Tokenist, which surveyed 4,852 participants ranging in age from 18 to 65 from seventeen countries, concluded:
- Over 45% of respondents preferred Bitcoin over stocks, real estate, and gold.
- 61% of the total respondents (and 78% of millennials) are now somewhat familiar with BTC
- Trust in Bitcoin has grown across generations since 2017, with 47% of respondents trusting Bitcoin over big banks, an increase of 29% in the past three years. 51% of millennials now trust Bitcoin over big banks.
- 44% of millennials report that they are likely to buy BTC in the next five years.
With the increasing popularity of cryptocurrencies as self-custodied assets, before even including your cryptocurrencies in your estate plan, it is imperative that you have an effective strategy for hanging on to your cryptocurrencies. This involves preserving the passwords and digital wallets (storage units) connected to your cryptocurrency. This will avoid a disastrous situation like the one that befell a Welsh man who accidentally threw away half a billion dollars’ worth of Bitcoin. Consider the following options to preserve your cryptocurrency:
- Hot wallet: An online app that provides convenience but is vulnerable to being hacked or stolen.
- Cold wallet: An offline storage device that avoids hacking but is a small item and easily misplaced.
- Custodial wallet: A third-party crypto exchange that holds your coins, avoiding the risk of losing the device, although the company could freeze your funds or be the target of a cyber-attack.
- Paper wallet: A printed list of keys and QR codes that is safe from hackers but easily misplaced.
Tax Consequences to Consider
Another important consideration is that the Internal Revenue Service (IRS) considers cryptocurrency to be property rather than currency. This means it is subject to capital gains tax. If the owner holds a cryptocurrency for longer than twelve months the IRS will assess long-term capital gains tax. Whereas, if the owner holds a cryptocurrency for less than twelve months the IRS will assess short-term capital gains tax. Investors should also be aware that exchanging cryptocurrency for fiat currency (a country’s official money) is a taxable event, as is exchanging one kind of cryptocurrency for another (e.g., exchanging Bitcoin for Cardano ADA). If you are in the business of selling or creating (called “mining”) cryptocurrency, ordinary income tax rates will apply.
What about NFTs?
NFTs are unique digital collectible items. They are based on the concept “I own this.” It does not matter what “this” is, just that it is valuable or may gain value someday. That is why various digital collectible assets, such as the following, can be characterized as NFTs:
- Digital artwork
- Video clips
- Social media posts
- Gaming tokens
- Digital real estate
While being the owner of the virtual Pyramid of Giza may seem silly today, who knows how much it will be worth tomorrow? This makes a little more sense when we think about emerging technologies like virtual reality, augmented reality, and metaverses. That is, some NFTs have practical applications and can be used, sold, or traded, in virtual worlds and games, just like tangible personal property can be in the real world. While the NFT market seems to have collapsed recently, you never know when it will bounce back or if something similar will take its place, particularly given that cryptocurrency price trends have been historically strongly correlated with Bitcoin’s halving cycle which takes place about every four years and creates a supply shock.
How Crypto and NFTs Fit into Your Estate Plan
Talk to an estate planning attorney familiar with cryptocurrencies and NFTs, even if you have not yet purchased your first Bitcoin or Cardano ADA. They can help you keep taxable events to a minimum and preserve your digital assets as part of your overall estate plan while maintaining your privacy.
Note: This content is for informational purposes only and should not be construed as legal, tax, investment, financial, or other advice. This information is not a comprehensive or complete statement of the matters discussed or the law relating thereto. If you seek legal advice regarding cryptocurrencies, please talk to an attorney.
This article was co-authored by WealthCounsel and Lucas Pastuszka.