The Two Biggest Risks of Owning Cryptocurrencies

The excitement of bitcoin and other cryptocurrencies has risen to the height of the casino run. The house holds the odds, but for the moment, the card gods are looking kindly upon the gambler.

Some say the run has just begun. As I write, bitcoin is north of $50,000 with at least one large investor feeling bitcoin is going to somewhere around $500,000 per bitcoin! Mark Cuban was not interested in plastic wristbands that promised more energy (a scam), but has no problem with owning cryptocurrency. Interesting. 

Then we have the other side of the, ahem, coin. Black Swan author, Nassim Nicholas Taleb, calls bitcoin and other cryptocurrencies a “game” and “gimmick”. He has a point. While fans of cryptocurrencies consider the digital currency the future medium of exchange, no cryptocurrency is considered legal tender anywhere on the planet.

Then we have the touted benefits. Bitcoin is safe, secure and anonymous. You don’t have to be up to no good to want your personal information private. And most feel strongly that the government should not have detailed financial information on its citizens. Facebook and Google, either.

The downside is that cryptocurrencies are not that safe. People lose the key or password to their crypto wallet and there is no way the retrieve the money. It is gone forever, like cash left in a burning house. And if you are diligent about safeguarding your password, the are stories of people losing serious money in stolen cryptocurrency.

I am not here to judge. Whether you love, hate or don’t care a lick about cryptocurrencies, they are here to stay for the foreseeable future. At some point you will be tempted to either invest in a cryptocurrency or accept it as a form of payment.

The pros and cons have been shouted from the rooftops by traditional media and trumpeted on social media ad nauseam. And all that shouting forgets to mention two very serious issues with bitcoin and other cryptocurrencies.

The first risk involves lost opportunity costs coupled with the realization more and more supply of cryptocurrencies will continue as long as there are buyers. This eventual realization will drive home the fact that nothing of value supports the price of any particular cryptocurrency. Most currency on the planet is fiat, or by decree of the government issuing the currency. Some would argue nothing backs this form of money either. But at least fiat money is usually legal tender, which means they must be accepted in the country of issuance as a form of payment for a debt.

The second rarely discussed risk is taxes, Yes, plenty has been said about the reporting of cryptocurrency transactions on your tax return. What I am talking about goes much further. There is a final endgame that must be reached and when it does there will be a taxocalypse for many people and businesses. 

Risk #1: Interest on Bitcoin and Other Cryptocurrencies

Interest rates have been scraping the floor for a decade and longer. Still, if you save money you have the possibility of earning interest on that savings. You can be even more certain you will pay interest if you borrow money. 

The interest rate a borrower asks covers risks of nonpayment, inflation, lost opportunity cost (could the lender earn more lending elsewhere) and the change in the value of the currency the money is lent in. 

Inflation and risk of nonpayment predominate almost all lending. The less financially sound the borrower, the higher the rate of interest changed to offset the risk. If inflation rears its ugly head you can be sure lending rates will go up for all borrowers. 

Lost opportunity cost plays a very small role because borrowers rarely consider alternative investments. They are in the business of lending money and lending money is a reasonably exact science. Credit scores, for example, allow all lender to see the same information when making a decision on lending funds. Different lenders have different rates. All loans from that particular lender will have the same interest rate (or reasonably so) for loans to borrowers with a similar financial makeup.

The value of the currency and its rate of change also play a small, if nonexistent role in lending rates. Most currencies change in value against other currencies by insignificant amounts on a daily basis. Periodically a currency will go into free fall. This is caused by high inflation which is caused by a government out of control in the money printing business. We saw some countries in Western Europe require bailouts recently due to loss of confidence. The rate of interest these countries had to pay was extremely high compared to other developed nations. The currencies suffered as a result. With uncertainty in the currency, few wanted to lend or borrow in that currency.

Now let’s relate this to cryptocurrencies. Bitcoin, as our example, can change in value more than the currency of a failing state. It is not uncommon for a cryptocurrency to change in value more than 20% in a single month. 

With such volatility in the currency, the risks to the lender and borrower are massive and go beyond the normal credit-worthiness of the borrower and the current and expected inflation rate. If everyone believes the cryptocurrency is going to continue climbing, lenders will be reluctant to borrow, except at extraordinary rates. Lending out their bitcoin would cost them the opportunity to benefit from the continued rise in the value of bitcoin. It would take a very high interest rate to seduce the lender to lend out their digital currency. 

Borrowers will have the opposite attitude. They will not be willing to borrow at such high rates with the risk that the cryptocurrency does not change in value as assumed. If bitcoin doesn’t climb in value enough the borrower is stuck with an even higher interest rate as compared to other currencies.  

Update: I was reminded you can deposit your virtual currencies and receive interest here. That means you can earn a return on your savings in cryptocurrencies. As a comment introduced me to this, I decided to sign up for the affiliate program. You could turn this accountant into a massive liar if you sign up with BlockFi using the link, as they pay $10 in bitcoin. (I said I would never buy a cryptocurrency. As for owning, well, that could be a different story.)

When was the last time you heard anyone worried about the change in the value of the dollar playing into their lending attitudes? When inflation ran high in the 1970s and and early 80s it was an issue. Inflation was killing the dollar, causing higher interest rates, and rates climbed to adjust for the currency devaluation (inflation) risk. High interest rates carry a higher risk. If the asset purchased with the borrowed funds does not appreciate at least as fast as the loan interest, the borrower is effectively paying a higher original price for the asset. 

Who wants to borrow 10 bitcoins to mortgage a home purchase when those same bitcoins might be worth $500,000 per bitcoin later? Unless you think you will see high inflation increasing your income, the risk is phenomenal. (Yes, if you are paid in bitcoin it affects the numbers.) Of course, you could borrow the bitcoins and hedge it against another currency like the US dollar. But that is the point. If everything goes back to legal currency, the cryptocurrency is just a high stakes gamble. Only when people start converting dollars to cryptocurrencies because the cryptocurrency is the overwhelmingly preferred mode of exchange, will cryptocurrencies replace legal tender. And that is unlikely because governments do not like to lose control over money within their borders.

There is a reason why opportunities to lend out your bitcoin are scarce and options to earn a return on saving in fiat money are numerous. At what rate would you lend out your bitcoin, knowing bitcoin could appreciate 50% or more over the next year? 

Until cryptocurrencies have a stable value will they be a serious form of exchange contender. That means lending out your cryptocurrency for a return is an unlikely option and one that could easily backfire. That leaves you with cryptocurrency appreciation or you will lose.

Risk #2: Taxes on Bitcoin and Other Cryptocurrencies

This one is easier to explain even though it is rarely discussed.

Cryptocurrencies are a pain in the tail to account for on the tax return. If held as an investment it in not a serious matter. If you use bitcoin to purchase goods and services, each transaction is considered a sale of bitcoin and needs to be reported on the tax return. 

If the cryptocurrency exchange gives you an annual printout the problem is muted. Drop the bottom line numbers on the tax return and scan and attach the printout. That is the easy part.

Since cryptocurrencies are pointing skyward, nobody asks about the consequences if bitcoin started to slide for a prolonged period of time. It is inevitable! Eventually the climb will stop and there will be times where the currency declines in value.

The IRS has provided guidance in Notice 2014-21. All virtual currencies are property according to the notice. That means each exchange of the virtual currency is a taxable event. We discussed that above.

What it also means is that if you are using bitcoin or any other cryptocurrency and you suffer a loss due to sale or purchase of a good or service, the loss can be limited. 

Under current law, capital losses are allowed to the extent of capital gins, plus up to $3,000 per year against other income. In laymen’s terms, all gains are taxable immediately while losses in excess of gains of more than $3,000 are carried-forward to future tax returns instead of being currently deducted.

At first glance this might not be such an issue. But once you consider the large changes in value many cryptocurrencies are experiencing, it is easy to see a taxpayer with large losses that will take decades or centuries to deduct. 

Why do I consider this such a serious risk? First, at some point virtual currencies will suffer a prolonged downturn. It is inevitable. When that happens, people who bought bitcoin with dollars already taxed will be unable to deduct the losses for a very long period of time, if ever.

Then we come to divorce. Where you live determines the rules. Regardless, it will not be fun.

We end with your end. When you die (as inevitable as bitcoin dropping in value some day) your unused tax losses are lost. Married couples living in marital property states might find a way to preserve half those losses.

Even worse, upon death there is a step-up in basis, or step-down! If your cryptocurrency appreciated then the step-up in basis to the value on the date of death will be a tax benefit. But if we are in the midst of the inevitable decline at the time of your demise, there will be a step-down in basis. Yes, that means it is possible to be double taxed if the virtual currency starts to climb again. (If you buy $100 of bitcoin (bought with money already taxed) and it declines to $50 on the date of your death, the basis is adjusted to $50. If bitcoin then climbs to $100, your beneficiaries will have a $50 gain if they sell at that time. $50 is double taxed!)

Parting Notes

I have never owned any cryptocurrency. I’m an investor, not a gambler. The risks are too great for this country accountant. Knowing the risks outlined at the beginning of this article coupled with the less often discussed risks listed in the heart of this article make virtual currencies unenticing to me. 

The tax issues surrounding cryptocurrencies add complexity where none is needed. As an investment, these virtual currencies rely upon the greater fool theory: you are counting on a greater fool to pay you more than what you paid for the virtual currency. I’m not trying to be rude. These digital currencies are backed by nothing. Blockchain is not a backing, only a security and anonymity feature. Like any currency bought and sold on the futures markets, you are either hedging or speculating. Businesses might consider hedging virtual currencies if they become widespread in use in trade. Everyone else is a speculator and needs to know it.

Again, I am not here to judge. It matters nothing to me if you invest in bitcoin or not. It’s actually good for my business, all those transactions to report.  If it is what you want to do, I have no problem with it. If someone is trying to talk you into buying a virtual currency, consider that you might be the greater fool.

And remember, the greatest fool is the last one holding the bag.

 

 

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