“Bitcoin is like anything else: it’s worth what people are willing to pay for it.”
Stanley Druckenmiller – American investor, hedge fund manager, and philanthropist
Cryptocurrency gained mainstream acceptance and attention as the market cap surpassed $3 trillion in November 2021. Bitcoin, the world’s most popular cryptocurrency, reached all-time highs in 2021 as the value exceeded over $65,000 per coin. In January 2022, Bitcoin dropped about 50% from its all-time-high, which is not unusual for the cryptocurrency market. Despite the volatility, Bitcoin is not going away, so we have answered 5 common questions clients are asking about it.
- What is Bitcoin?
Created in January 2009, Bitcoin is the first decentralized digital currency. It is sometimes referred to as a virtual currency or a cryptocurrency. Bitcoins are held in a digital wallet and can be sent over the internet (there are no physical bitcoins). Bitcoin transactions are authorized using a digital signature and then verified by a network of miners. Once verified, the transaction is permanently stored on a public ledger known as the blockchain. Bitcoins are created, distributed, traded, and stored with the use of the blockchain.
- How are Bitcoins created?
New bitcoins are “mined” through a meticulous process of verifying transactions. Bitcoin miners receive bitcoins as a reward for completing “blocks” of verified transactions, which are added to the blockchain. In essence, miners are paid to be auditors, a process that strengthens the integrity of the Bitcoin network and prevents double-spending in the system. As of January 2022, there were just under 19 million bitcoins in circulation, out of an ultimate total of 21 million.
- Should I invest in Bitcoin?
It depends, but a general rule of thumb is to only invest what you can afford to lose. Supporters of Bitcoin see a bright future ahead. Bitcoin’s broad and growing acceptance as an alternative store of value and as a new form of payment are considered core reasons for owning the asset. Because its supply is limited to 21 million coins, some enthusiasts argue it has a greater store-of-value than other currencies and is more defensively positioned against inflation risk.
In addition to cyber security concerns, there are other risks to keep in mind. Bitcoin’s price fluctuations up and down can be extreme. There is little financial regulation in the world of crypto, which can question whether cryptocurrency is a safe investment for individual investors. The Securities and Exchange Commission is hoping to boost investor protections in the space. Although Bitcoin is the leader in the cryptocurrency market cap, there is a growing list of alternatives such as Ethereum and Litecoin.
- How can I buy Bitcoin?
For direct purchases, investors need a digital wallet to securely hold their bitcoins offline. Several of the well-known wallet operators include Coinbase, Electrum, and Ledger. Investors should be careful which platform they choose, because they may not actually own the bitcoins that they are buying. For example, the crypto in a PayPal account cannot be transferred to other accounts on or off the platform. There are also several securitized products, including Grayscale Bitcoin Investment Trust (GBTC), that investors can trade in their brokerage accounts.
- Is Bitcoin taxable as an investment?
Yes. The IRS classifies bitcoins as property, rather than a currency. If you recently filed your individual income tax return, you may have noticed a question on page 1: “At any time during 2021, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?” U.S. taxpayers must calculate the amount of their gain or loss on every single transaction involving bitcoin.