What is Cryptocurrency & How is it Stored?

Cryptocurrency is a form of digital money that is designed to be secure and, in many cases, anonymous. It is a currency associated with the internet that uses cryptography, the process of converting legible information into an almost uncrackable code, to track purchases and transfers. Bitcoin has become the leader in shepherding in a wave of cryptocurrencies built on a decentralized peer-to-peer network, it’s become the primary standard for cryptocurrencies. The currencies inspired by Bitcoin are collectively called Altcoins and have tried to present themselves as modified or improved versions of Bitcoin. While some of these currencies are easier to mine than Bitcoin is, there are tradeoffs, including greater risk brought on by a degree of lesser liquidity, acceptance and value retention.  Some of the more popular types of cryptocurrencies are Bitoins, Ethereum, Litecoins, Ripple, Zcash, and Dash.

Bitcoin mining is the process by which transactions are verified and added to the public ledger, known as the block chain, and also the means through which new Bitcoins are released.  Anyone with access to the internet and suitable hardware can participate in mining, although, it is far from easy and requires certain equipment and a whole lot of electricity.  The mining process involves compiling recent transactions into blocks and trying to solve a computationally difficult puzzle.  The participant who first solves the puzzle gets to place the next block on the block chain and claim the rewards.  The rewards, which incentivize mining, are both the transaction fees associated with the transactions compiled in the block, as well as newly released Bitcoin. The amount of new Bitcoin released with each mined block is called the block reward.  The block reward is halved every 210,000 blocks, or roughly every 4 years.  The block reward started at 50 in 2009, is now 25 in 2014, and will continue to decrease.  This diminishing block reward will result in a total release of Bitcoin that approaches 21 million.  A Bitcoin holds a very simple data ledger file called a block chain. Each block chain is unique to each individual user and his/her personal Bitcoin wallet. All Bitcoin transactions are logged and made available in a public ledger, helping ensure their authenticity and preventing fraud. This process helps to prevent transactions from being duplicated and people from copying Bitcoins. While every Bitcoin records the digital address of every wallet it touches, the Bitcoin system does not record the names of the individuals who own wallets. In practical terms, this means that every Bitcoin transaction is digitally confirmed but is completely anonymous at the same time. Hence, people cannot easily see your personal identity, however, they will be able to see the history of your Bitcoin wallet.

Cryptocurrencies are generally as secure as possessing physical precious metal. Just like holding a gold bar, a person who takes reasonable precautions will be safe from having their personal cache stolen by hackers.  This is especially true if you keep your wallet private key safe and secure and do not give it to anyone. A Bitcoin wallet can be stored online (i.e. a cloud service) or offline (a hard drive or USB stick). The offline method is more hacker-resistant and absolutely recommended for anyone who owns more than 1 or 2 cryptocurrency coins, but it is not without risk.

The Importance of Controlling Your Own Cryptocurrency Wallet

In a virtual currency system, a user creates a “wallet.” A wallet is a digital computer file that contains information used in sending and receiving units of a virtual currency. When the wallet is created, a random wallet address is generated; this is a unique alphanumeric identifier, which is conceptually similar to an e-mail address. The wallet would have a public key and private key.  The public key is essentially the public address of the wallet, whereas, the private key is only known to the wallet holder.  Without the private key, you will not have access to the wallet and thus would not be able to access the cryptos held in the wallet.  On the flip side, anyone who has your private key essentially owns the content of the wallet.  This is why it is so important to always keep your private key confidential, safe and secure.  Do not reveal it to anyone you do not wish to have access to your wallet. Think about it like this: assume you had a glass bowl with a lock.  Inside the glass bowl is a gold coin.  Anyone can see the glass bowl, which is your public key.  The gold coin contained in the glass bowl is the Bitcoin address. However, only the keyholder can actually open the glass bowl and get the coin.  The key to the glass bowl is the private key.  It’s like your ATM card pin number.  Bitcoin users can have multiple wallets.

Wallets can be in the form of digital, online, hardware, or paper.  A digital wallet allows you to access your cryptos on a phone or android application.  Online wallet is literally a web-based wallet and it is the easiest to use. Online wallets store your private keys on a computer connected to the Internet and controlled by someone else. Whereas, a hardware wallet is a special type of bitcoin wallet, which stores the user's private keys in a secure hardware device. A hardware wallet is considered one of the safest way to hold cryptocurrencies. While a paper wallet is a document containing all of the data necessary to generate any number of Bitcoin private keys, forming a wallet of keys.

How are Cryptocurrencies Treated by the IRS?

Even though Bitcoin is labeled as a “cryptocurrency”, from a Federal income tax standpoint, Bitcoins and other cryptocurrency are not considered a “currency.”  On March 25, 2014, the IRS issued Notice 2014-21, which for the first time set forth the IRS position on the taxation of virtual currencies, such as Bitcoins.  According to the IRS Notice, “Virtual currency is treated as property for U.S. federal tax purposes.” The Notice further stated, “general tax principles that apply to property transactions apply to transactions using virtual currency.”  In other words, the IRS is treating the income or gains from the sale of a virtual currency, such as Bitcoins, as a capital asset, subject to either short-term (ordinary income tax rates) or long-term capital gains tax rates, if the asset is held greater than twelve months (15% or 20% tax rates based on income).  By treating Bitcoins and other virtual currencies as property and not currency, the IRS is imposing extensive record-keeping rules - and significant taxes - on its use.

Does the IRS Allow Retirement Accounts to Purchase Cryptocurrencies?

The Internal Revenue Code does not describe what a Self-Directed IRA or Solo 401(k) Plan can invest in, only what it cannot invest in. Internal Revenue Code Sections 408 & 4975 prohibits Disqualified Persons from engaging in certain types of transactions. The foundation of the prohibited transaction rules is based on the premise that investments involving an IRA and related parties are handled in a way that benefits the retirement account and not the IRA owner. The rules prohibit transactions between the IRA and certain individuals known as “disqualified persons.” The definition of a “disqualified person” (Internal Revenue Code Section 4975(e)(2)) extends into a variety of related party scenarios, but generally includes the IRA holder, any ancestors or lineal descendants of the IRA holder, and entities in which the IRA holder holds a controlling equity or management interest.

Because the IRS treats cryptocurrencies, such as Bitcoins, as a capital asset, such as stocks or real estate, a retirement account is permitted to buy, sell, or hold cryptocurrencies in their retirement subject to the prohibited transaction rules found under Internal Revenue Code Section 4975(c).

Tax Advantages of Using a Self-Directed IRA LLC to Invest in Cryptocurrency

The IRS tax treatment of virtual currency has created a favorable tax environment for retirement account investors.  In general, when a retirement account generates income or gains from the purchase and sale of a capital asset, such as stocks, mutual funds, real estate, etc., irrespective of whether the gain was short-term (held less than twelve months) or long-term (held greater than twelve months), the retirement account does not pay any tax on the transaction and any tax would be deferred to the future when the retirement account holder taxes a distribution (in the case of a Roth IRA or Roth 401(k) Plan no tax would be due if the distribution is qualified).  Hence, using retirement funds to invest in cryptocurrencies, such as Bitcoins, could allow the investor to defer or even eliminate, in the case of a Roth, any tax due from the investment.  Note – retirement account investors interested in mining Bitcoins versus trading, could become subject to the Unrelated Business Taxable Income tax rules if the “mining” constituted a trade or business.

So, why use a Self-Directed IRA LLC to Buy Cryptocurrencies?

  • Gains are tax-free.
  • No time limit for holding property – no need to worry about 12 month holding period for long term capital gain treatment.
  • Potential to earn a larger rate of return on invested capital.
  • Invest in what you know and understand.
  • Diversify your retirement portfolio from over-exposure to Wall Street.
  • Protect your retirement funds from inflation or a falling U.S. dollar.
  • Invest with privacy.

How to Use a Self-Directed IRA LLC to Invest in Cryptocurrency – The Wallet Control IRA

  1. Wallet Control Self-Directed IRA LLCEstablish a Self-Directed IRA account.
  2. Rollover retirement funds, cash or in-kind, tax-free to new Self-Directed IRA account.
  3. The IRA assets will then be transferred to the LLC tax-free in exchange for 100% interest in the newly established IRA LLC.
  4. You, as manager of the LLC, will open a bank account for the LLC at any local bank.  IRA Financial Group will draft an LLC Operating Agreement identifying you as manager of the LLC and the IRA as the sole member.
  5. You, as manager of the LLC, will then have “Checkbook Control” over all the assets/funds in the IRA LLC to make the cryptocurrency investment.
  6. A cryptocurrency account would be opened in the name of the IRA LLC. We have helped hundreds of clients establish cryptocurrency accounts for their Self-Directed IRA LLC at most of the popular cryptocurrency exchanges.
  7. You, as manager of the LLC, will then wire the IRA LLC funds to the new cryptocurrency account opened at the exchange. The account will be opened in the name of the IRA LLC. As manager of the LLC you will have the option of keeping the cryptos on an exchange, such as Coinbase, or move them to a digital or hard wallet you control and where you hold the private key.
  8. Since the LLC is owned 100% by an IRA, it will be treated as a disregarded entity for tax purposes. No Federal income tax return is required to be filed and all income and gains from the cryptocurrency investment will flow back to the IRA without tax.

Why Do I Need to Use an LLC To Have My Self-Directed IRA Purchase Cryptocurrencies?

In general, there are two ways to invest in cryptocurrencies with a Self-Directed IRA: (i) the custodian controlled Self-Directed IRA, and (ii) the Self-Directed IRA LLC.  Investing in cryptocurrencies with a Self-Directed IRA is viewed by many as quite risky, since the cryptocurrency wallet is generally held by a third-party. In other words, the IRA owner does not have control over the cryptocurrency wallet and is not in possession of the wallet private key.  In addition, each time the IRA wishes to buy or sell cryptocurrencies, they are required to go through the IRA custodian or affiliated broker, which can elicit high commissions of up to 5% on each transaction. 

IRA Financial Trust believes the Self-Directed IRA LLC solution is a far more secure and cost- effective platform for retirement investors who are interesting in purchasing cryptocurrencies.  With our “Wallet Control” IRA, the IRA owner, as manager of the LLC, will have total control over the cryptocurrencies held by the LLC.  The LLC manager will then be able to open an exchange account in the name of the LLC and hold the coins on the exchange or on a wallet, either digital, online, hard, or paper.  In addition, the IRA holder will then be able to sell the cryptos through any exchange and have more control over the associated fees and costs involved. The “Wallet Control” IRA gives the IRA holder total control over the cryptocurrencies, wallet, and private key, as well as offer a cost-efficient way to buy and sell the cryptocurrencies.

Cryptocurrency investments, such as Bitcoins, are risky and highly volatile.  Any investor interested in learning more about Bitcoins should do their diligence and proceed with caution.

Before using a Self-Directed IRA to purchase tax liens, you should consult with your financial or tax advisor to make sure the investment is suitable and right for you.

To learn more about purchasing tax liens or deeds with a Self-Directed IRA, please contact a Self-Directed retirement expert at 1-800-472-1043.