Bitcoin and Beyond: The Basics of Cryptocurrency
Written by: Kristy Welsh
Last Updated: September 7, 2017
If you’re looking for investment ideas, cryptocurrency might be looking pretty good right now. On August 27, 2017, the total market capitalization of cryptocurrencies reached $158.5 billion, an increase of 795 percent for the year. What doesn’t look so good is jumping into an investment before you understand it. At least get the basics down first.
How cryptocurrency works
Cryptocurrency is a decentralized digital currency, with no single governing body issuing it or regulating the market. There are hundreds of cryptocurrencies in circulation, which can be acquired in a few different ways:
- They can be bought through an exchange
- They can be paid to you by an employer
- They can be mined
Mining is done by participating in the processing of cryptocurrency transactions. A good explanation comes from The Economist in its description of mining Bitcoin:
"Every ten minutes or so mining computers collect a few hundred pending bitcoin transactions (a ‘block’) and turn them into a mathematical puzzle. The first miner to find the solution announces it to others on the network. The other miners then check whether the sender of the funds has the right to spend the money, and whether the solution to the puzzle is correct. If enough of them grant their approval, the block is cryptographically added to the ledger and the miners move on to the next set of transactions (hence the term ‘blockchain’)."
It is this mining activity that earns you cryptocurrency. (Though not all cryptocurrency can be mined.)
Once it is in your possession, you can hold on to your cryptocurrency in hopes of it rising in value. You can sell your cryptocurrency. Or you can spend it in places that accept cryptocurrency as payment.
How to trade cryptocurrency
You buy and sell cryptocurrency through an exchange. To get started, you will need to sign up for an account, verify it, and add your preferred payment methods. One of the most popular exchanges is Coinbase. But there are many other trusted exchanges, Bitstamp, Gemini, and Kraken among them.
When to buy (and sell) cryptocurrency
Though cryptocurrency is not a stock, some conventional stock advice does apply — buy low, sell high. Also, consider the advice of Credit Info Center owner Jared Ericksen who trades on Coinbase:
"Buy and hold until you absolutely need to withdraw the money. I have played around with trying to guess the valleys and peaks. I have also just bought and held and the latter has performed much better."
But make no mistake about it — there is nothing safe or predictable about cryptocurrency. "I would classify it as a risky investment for sure," says Ericksen. "Only invest money that you can afford to lose."
Buy and sell limits
Though cryptocurrency is not regulated by any single governing body, the exchanges do have their own internal rules, buy and sell limits among them. Take Coinbase, for example, the most popular cryptocurrency exchange.
As stated on the Coinbase website, "Your account has a weekly limit for buying and selling as well as separate credit / debit card limits, applicable to certain payment methods."
These limits can increase relative to 1) how long you’ve had your Coinbase account, 2) your buying history and activity, and 3) account verification.
What cryptocurrency to invest in
There are hundreds of cryptocurrencies out there, so deciding on one can feel a little overwhelming. On the other hand, your options may be very limited depending on which cryptocurrency exchange you use. For instance, Coinbase only trades in Bitcoin, Ethereum, and Litecoin.
Where to spend cryptocurrency
If you want to spend your cryptocurrency on goods or services, you can use Bitcoin through a few name brand sources, including Overstock, Expedia, Shopify, DISH Network, Microsoft, Intuit, and Paypal.
How cryptocurrency is taxed
Despite its name, cryptocurrency is not considered currency by the IRS. It is instead considered property, meaning cryptocurrency is subject to capital gains taxes. Federal income taxes may also apply. Specifically, the IRS website states that:
- Wages paid to employees using virtual currency are taxable to the employee, must be reported by an employer on a Form W-2, and are subject to federal income tax withholding and payroll taxes.
- Payments using virtual currency made to independent contractors and other service providers are taxable and self-employment tax rules generally apply. Normally, payers must issue Form 1099.
- The character of gain or loss from the sale or exchange of virtual currency depends on whether the virtual currency is a capital asset in the hands of the taxpayer.
- A payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property.
Who created cryptocurrency
Bitcoin was the first cryptocurrency, created in 2009 by an inventor who goes by the pseudonym, Satoshi Nakamoto. However, the system that cryptocurrency is based on was used during World War II, when cryptography was used to encrypt communications.
When to think twice
Before jumping into the cryptocurrency market, ask yourself these questions first:
1) Do you already have traditional investments for your retirement?
2) Have you paid off all outstanding credit card debt?
3) Have you saved the money you need for your financial goals? College, a car, a home?
4) Is the money you would invest in cryptocurrency money you can afford to lose?
If you can answer yes to all of these questions, go for it. If not, think twice. Instead of making a risky investment, why not use the money to accomplish things you know to be within your reach?