Owning Bitcoin May Complicate Your Estate Plan and Income Taxes
By: Anthony J. Enea, Esq.
The ownership of any digital currency, whether it be Bitcoin or any other cryptocurrency, has, by its very nature, inherent complexities. One particularly complexity is issue of its taxation and how to legally dispose of the cryptocurrency upon one’s demise.
In spite of most references to Bitcoin or other cryptocurrencies as being a “digital currency,” the IRS in Notice 2014-21issued on March 25, 2014 made it clear that, for purposes of federal taxation in the U.S., Bitcoin is to be treated as “property.” Thus, like all other forms of “property,” the principles of taxation that apply to property transactions apply to the transactions involving cryptocurrencies. For example, income taxation thereof, short and/or long-term capital gains and/or losses and their applicable tax rates need to be applied to transactions involving Bitcoin or any other cryptocurrency.
Even the use of a cryptocurrency to purchase goods and services has the potential for income taxation, or losses, as there could be income taxes due on the difference between the value of the cryptocurrency at the time it was purchased, and its fair market value when spent on the goods or services. This taxation can also occur when it is converted into U.S. dollars. Unfortunately, the use of any cryptocurrency to make purchases is often the area of greatest potential taxation for its owner. This occurs because almost every transaction involving a cryptocurrency results in a taxable event that may generate capital gains or losses. For example, you purchased one Bitcoin for $6,000.00 U.S. dollars and you purchased a motorcycle with said Bitcoin for $10,000.00. Depending on how long you held the Bitcoin before you made the purchase, there could be a short- or long-term capital gain.
Since a cryptocurrency is treated as property by the IRS, extensive and detailed record keeping is needed. The failure to adequately keep records of transactions could potentially come back to haunt one’s family and estate if contemporaneous records are not kept and income taxes not paid on the transactions annually. The prospect of an IRS audit is real. This is also an area where most cryptocurrency owners seek to avoid taxation.
On the positive side, upon the death of a Bitcoin or other cryptocurrency holder, the beneficiaries of said cryptocurrency will receive the cryptocurrency at its fair market value on the holder’s date of death (§1022 of the Internal Revenue Code). Their cost basis is stepped up to its date of death value as it is includible like any other property in the decedent’s taxable estate, subject to federal and state estate tax laws and their applicable estate tax credits.
Because of its digital nature, there is no tangible documentary evidence of the cryptocurrency’s existence. There is no Bitcoin bank statement. In essence, its owners engage in direct transactions with each other. There are more than 100,000 merchants that accept Bitcoin as payment. As of the date of this writing, one Bitcoin is worth nearly $4,000 U.S. dollars. The transactions in Bitcoins are recorded in a publicly distributed database known as a “blockchain.” The blockchain is constantly and regularly updated. It is within the blockchain where the Bitcoin exist.
While the name of the Bitcoin owner is not publicly recorded, one’s ownership is tied to a specific Bitcoin address. This is where the potential problem exists for not only the holder, but also his or her heirs. One’s Bitcoin or cryptocurrency can only be accessed by the holder of its two digital keys. One key is public and the other is private. There can be one or more private keys. The private key is, in essence, the secret number that allows the cryptocurrency to be spent. It is a randomly generated string of numbers and letters.
A problem exists if the private key is lost because then there is no way to access the Bitcoin. Generally, both keys are stored in a digital wallet by the holder. The public key is used to ensure you are the owner of an address that receives funds. It is related to one’s wallet.
Because Bitcoin and any other cryptocurrency is treated as property, it can be distributed by one’s Last Will and Testament and be also assigned/transferred to one’s Revocable and/or Irrevocable Trust. This would require that the Trust be the holder of the Bitcoin in the blockchain. Even if one’s heirs, executor(s), and trustee(s) know of the existence of the Bitcoin, if they do not know of both digital keys (public and private), the Bitcoin cannot be accessed and distributed to one’s beneficiaries. It would be, for all practical purposes, lost in the blockchain.
This problem is unfortunately similar to that facing the owners of all types of digital assets. One’s passwords, keys, etc. must be divulged to one’s family and those tasked with handling one’s affairs. Having knowledge of the two keys (both public and private) is also a dilemma if the Bitcoin holder is taken ill and/or is incapacitated. The named agent under his or her Power of Attorney would not be able to access the Bitcoin without knowledge of the private key and if the Power of Attorney does not specifically refer to digital assets and/or the cryptocurrency.
Because of the volatile nature of Bitcoin and other cryptocurrencies, it is also imperative that the executor/trustee of an estate and/or trust be aware of its volatility and take all necessary steps to seek to comply with the Prudent Investor Actas provided for in §11-2.3 of the NY Estates, Powers and Trusts Law and diversify the holdings in the Trust and/or estate. Even ownership of just a little bit of Bitcoin can end up creating headaches.
In conclusion, although an interesting, volatile, and perhaps potentially profitable investment, the ownership of a cryptocurrency has a number of pitfalls that need to be considered before one becomes an owner.