Guide to Investing in CryptocurrenciesUpdated: June 6, 2021
As cryptocurrencies have skyrocketed in popularity (and value), more and more service members have decided to get in on the action. But, for the uninitiated, the world of cryptocurrencies can seem completely foreign. To help, we’ll use this article as a guide to investing in cryptocurrencies.
Specifically, we’ll discuss the following:
- What are Cryptocurrencies?
- How to Invest in Cryptocurrencies
- Risks of Investing in Cryptocurrencies
- Cryptocurrency Tax Implications
- Final Thoughts
Not financial or tax advice. This article is strictly educational and is not investment advice.
What Are Cryptocurrencies?
According to the IRS, a cryptocurrency: […] Is a type of virtual currency that utilizes cryptography to validate and secure transactions that are digitally recorded on a distributed ledger, such as a blockchain. But, unlike traditional currencies like the US dollar, no central government or financial authority controls cryptocurrencies. Rather, mathematics and the decentralized control enabled by this distributed, publicly-available ledger “regulate” cryptocurrencies. Basically, because anyone can see this virtual ledger, people are incentivized to follow the rules.
As a virtual currency, cryptocurrencies also function as a medium of exchange. That is, using this blockchain technology, two people can exchange cryptocurrency to settle a transaction (e.g. one person transfers an agreed upon amount of cryptocurrency to another to purchase an automobile). For instance, Bitcoin, one of the most popular cryptocurrencies, provides both public and private signatures to all users. That way, in a transaction, the sender and receiver must sign off on the exchange with both of these signatures, which are automatically verified for accuracy.
However, unlike the US dollar or other fiat currencies, the value of cryptocurrency is not supported by the good faith of a government. Rather, crypto values fluctuate based on the whims of the market and the associated supply and demand factors. This means that, in the right situations, the value of cryptocurrencies can skyrocket. But, the opposite remains true – market factors can lead to massive collapses in cryptocurrency value.
Due to this volatile nature, many people now view cryptocurrency primarily as an investment – not a medium of exchange. If you think the value of your crypto holdings could increase from $20 to $2,000, why would you risk buying a pizza with your cryptocurrency worth $20 today? In other words, people now see investing in cryptocurrencies as a way to make a significant amount of money – not buy things.
Bitcoin was the first cryptocurrency, but it’s no longer the only one. Since its creation in 2009, thousands of other cryptocurrencies have entered the market. Bitcoin remains the largest by market share, but here are some of the major alternatives:
- Binance Coin
Each cryptocurrency has its own unique characteristics, meaning investors should carefully weigh the pros and cons of each sort before purchasing any for investment purposes. But, as the longest-established cryptocurrency, Bitcoin is generally viewed as the most reliable of these cryptocurrencies.
How to Invest in Cryptocurrencies
Prior to buying cryptocurrencies, people should first understand that “investing” is a bit of a misnomer. When you buy a cryptocurrency, you don’t receive dividends, interest, or rents like you would with other investments. Instead, you bet that you can sell your holdings for more than you bought them. As a result, purchasing cryptocurrencies is more speculation than investing.
Having said that, you can potentially make a lot of money on a smart crypto purchase. If willing to accept the risks for these potential returns, the question becomes, how do I actually buy cryptocurrencies?
To purchase crypto, most people use cryptocurrency exchanges. With these exchanges, users register an account and are then able to:
- Buy cryptocurrencies with fiat currencies (e.g. US dollars, Euros, etc.)
- Buy and sell cryptocurrencies using other cryptocurrencies
As with traditional currency exchanges, users will see real-time prices on these exchanges. For example, if a given cryptocurrency is trading at $15, you can purchase 100 units of that particular currency for $1,500 ($15 x 100).
Hundreds of cryptocurrency exchanges exist, but some of the most popular ones include:
Additionally, these exchanges host what’s known as a crypto wallet, a tool for holding all the cryptocurrency you hold. With an online exchange, the incorporated crypto wallet is a web-based one. This gives you the advantage of being able to access your holdings from any internet-connected device. But, an online wallet also creates the associated risk that someone can hack into that wallet.
Exchanges vs. Wallets
You can also purchase cryptocurrency directly from other people, that is, not on an exchange. But, to do this, you’ll need a crypto wallet. While most exchanges include embedded wallets, a wallet and exchange are actually two different things. An exchange lets you purchase cryptocurrency on the open market, whereas a crypto wallet stores all of your cryptocurrency holdings.
With a wallet embedded on an exchange, you inherently sacrifice some privacy, as you do not have complete control over that wallet. Alternatively, you can use a dedicated crypto wallet. Most of these are held offline, which A) grants you full control, and B) minimizes the likelihood of someone hacking into it to steal your crypto holdings via an exchange vulnerability.
Cryptocurrency Investing Steps
Having outlined the uses – and differences – of a cryptocurrency exchange and wallet, here are the standard steps to investing:
- Step 1: Register with a cryptocurrency exchange.
- Step 2: Connect your bank account to the exchange.
- Step 3: Submit a purchase order for cryptocurrency.
- Step 4 (optional): Transfer your purchases into a dedicated cryptocurrency wallet.
Once you complete Step 3, you have effectively traded your US dollars for cryptocurrency. When you decide to sell some of these holdings, you simply reverse the steps. Instead of creating a purchase order on an exchange, you create a sell order, selling your holdings for the current market rate.
Risks to Investing in Cryptocurrencies
Before investing in cryptocurrencies, you should consider the below risks.
Cryptocurrencies represent one of the most volatile asset classes currently available. While stocks regularly go up and down, they rarely face the same level of astronomical growth immediately followed by massive crashes that come with cryptocurrency investments. Bottom line, be prepared for massive value swings – for better or worse – with your crypto holdings.
Lack of Regulation
Unlike government currencies and publicly-traded stocks and bonds, cryptocurrencies are not regulated. To some, this serves as a tremendous advantage (e.g. criminals who want to avoid government scrutiny and money trails). But, this lack of oversight also presents tremendous risk, as you largely have no legal recourse if anything happens to your crypto holdings (e.g. you lose them when your cryptocurrency exchange is hacked, which has occurred multiple times).
Valuation Difficulties and Speculative Nature
As stated, individuals do not invest in cryptocurrency – they speculate. That is, they buy the cryptocurrency in the hope that it’s value will increase and they can resell holdings for a profit. This is due to the fact that, unlike more traditional assets like stocks, bonds, and real estate, no standard valuation model exists for cryptocurrency. As it doesn’t produce income (like a company or rental real estate), cryptocurrency value is derived solely from what the market will pay for it. In other words, many crypto speculators adhere to the “next dumbest person” philosophy, betting that someone will be willing to buy the cryptocurrency for more than they paid.
Cryptocurrency Tax Implications
In addition to the above cryptocurrency risks, borrowers should also consider the potential tax implications. Due to the fact that the IRS treats cryptocurrency as property, sales are subject to property-related taxes. In other words, if you sell your holdings for more than you purchased them, you will be subject to capital gains taxes. And, depending on how long you hold that cryptocurrency, you’ll either pay ordinary income tax rates or the more favorable long-term capital gains rates.
If unsure of the tax implications of a cryptocurrency sale, you should consult with a tax professional. With proper planning and tax strategies, you can at least minimize the tax bill you’ll face for a sale.
Investing in cryptocurrencies offers the potential for huge returns. But, it can just as easily lead to massive losses. Before using this guide to invest, be sure to consider the associated cryptocurrency risks. As a rule of thumb, you shouldn’t invest more in crypto than you’re willing to completely lose – as that could realistically happen.
Maurice “Chipp” Naylon spent nine years as an infantry officer in the Marine Corps. He is currently a licensed CPA specializing in real estate development and accounting.