Estate Planning and Tax Issues for Bitcoin and Other Virtual Currencies

For estate planning and tax advisers, it’s important to know about all of a person’s valuable and significant assets, including digital assets, so that they can help the person properly plan ahead for incapacity, death, and taxes. New types of assets are being created in and only exist in the digital world, including virtual currencies like Bitcoin and Dogecoin.

I recommend reading the May 14, 2014, article, “Bitcoin Is Creating New Headaches for Estate Planners, Though it May Someday Cure Them,” written by Joseph Wright. I was interviewed for this article and quoted in it. The article describes Bitcoin, estate planning obstacles regarding digital assets, and the Uniform Law Commission’s Fiduciary Access to Digital Assets act. This article is reprinted with permission from Electronic Commerce & Law Report™, 19 ECLR 607 (May 14, 2014). Copyright 2014 by The Bureau of National Affairs, Inc. (800–372–1033)

Although there are over 200 virtual currencies in use currently, Bitcoin is by far the most recognized and widely-used. Bitcoin has been in the news for its dramatic rise and fall in value recently. In May 2010, when Bitcoin was still relatively new, a person in Jacksonville, Florida, paid 10,000 bitcoins (worth about $41.00 at the time) for two large Papa John’s pizzas. Since then, at several times in late 2013 and early in 2014, the price per bitcoin jumped to about $1,000—making that a $10 million pizza (in hindsight)! You can check the current price per bitcoin at CoinMarketCap.

The IRS recently issued Notice 2014-21 to describe how they will apply U.S. tax principles to virtual currency. In general, the IRS treats virtual currency as property for federal tax purposes, valued in U.S. dollars. So, the virtual currency has a tax basis, and a person realizes gain or loss when the virtual currency is exchanged for other property. It is not treated as a currency that could generate foreign currency gain or loss for federal tax purposes.

Bitcoins are created by “mining,” which is done by using a significant amount of computing power to solve increasingly complex mathematical equations (a “block”) used for the virtual currency. For example, one high-end personal computer with a mid-range graphics card (the graphics card can significantly accelerate the computations involved) might be able to mine one Bitcoin block in just over three years, on average. Under Notice 2014-21, when a person mines and receives virtual currency, the IRS treats that as an income event for the person.

Finding virtual currencies after a person dies or becomes incapacitated can be a significant challenge because of the variety of ways they can be “stored.” Bitcoin, for example, is referred to as a “cryptocurrency” because it’s based on the principles of public key cryptography and relies on two separate “keys,” one public and one private, that are mathematically linked to represent bitcoins. A Bitcoin “address” is the public key. Think of it like an e–mail address—it’s used for sending or receiving bitcoins in a transaction. But, unlike an e–mail address, it’s generally recommended for security and privacy that a different Bitcoin address be used for each separate Bitcoin transaction. A Bitcoin private key is kept secret by the Bitcoin owner because it enables bitcoins to be transferred.

Multiple private keys are held in a “wallet” (think of a Bitcoin wallet like a bank account). One or more wallets can be stored on a computer, smartphone, online service, or offline (referred to as “cold storage”). To protect against the risk of theft or loss of bitcoins, a person may have multiple wallets for their bitcoins. Multiple wallets and multiple possible storage locations for the wallets can make it more difficult for fiduciaries to find bitcoins or other virtual currencies after a person’s incapacity or death.

A Bitcoin transaction requires the sender’s Bitcoin address, the recipient’s Bitcoin address, and the number of bitcoins to transfer, and this information is “signed” using the sender’s Bitcoin private key, which proves the sender owns the transferred bitcoins and can be verified by the Bitcoin network.

You can read more about my estate planning tips and strategies for dealing with Bitcoin in the BNA Bloomberg article that is linked above in the second paragraph.

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