What are Cryptocurrencies and Bitcoin?

(January 25, 2018)  If you have been following the news recently, you likely have heard buzzwords like “Bitcoin” “cryptocurrency” and “blockchain”, but might not fully understand the concepts behind digital currency. This is the first of a series of writings about cryptocurrencies, tax implications for owning cryptocurrencies, and how to effectively plan for cryptocurrencies in your estate.

A cryptocurrency is an electronic money that utilizes technology controlling its creation and protection, without disclosing the identity of its users. Cryptocurrencies are unique because they do not rely on government or bank created money. Users can send cryptocurrencies directly without a middleman, making transactions quick, reliable and affordable. Bitcoin was the first and the most well known cryptocurrency, but others rising in popularity include Ethereum, Ripple, Litecoin, Bitcoincash and many others. Units of these cryptocurrencies are often referred to as “tokens.”

While the cryptocurrency user’s identity is private, cryptocurrency transactions are publicly available and recorded in a digital record known as the “blockchain.” Blockchain is technology for creating permanent, secure digital recordings that does not rely on any single person or group, as the “blocks” are kept by many different computers across the world.   Blockchain technology makes its nearly impossible for hackers to manipulate transactions or access banking data as they would need to simultaneously hack all the computers across the world that record the digital transaction.

“Mining” is the process of registering transactions on the blockchain. Because this requires advanced computer work, any person that completes this process is rewarded with digital money. This is how new tokens are made. While different cryptocurrencies have different mining processes, Bitcoin uses a complicated math puzzle, and the first to solve it receives a bitcoin as a reward.

Many people purchase existing tokens using local currency, through cryptocurrency exchanges, such as Coinbase. Most exchanges are centralized and hold funds for you in an account that allows you to trade between local currency and cryptocurrency. Individuals protect their tokens using their digital wallet. A “wallet” is software that can only be accessed by using a key. Many exchanges have their own wallets, most of which are “hosted wallets,” meaning you do not hold what are known as “private keys,” or the actual cryptocurrency itself. “Non-hosted” wallets can only be accessed by using your private keys, which are long strings of letters and numbers. It is vitally important to keep your keys private, as anyone who knows them can access your tokens.

Timoney Knox will be posting additional articles about cryptocurrencies and how to effectively plan for your estate and taxes. If you have any questions, do not hesitate to contact us.  (Amanda M. Kita, Esquire)