Taking a Bite Out of Bitcoin
By Steven Higgins, Financial Advisor, Principal
Bitcoin is a major news story right now. The crypto-currency has made headlines as the value of Bitcoin is on a rocket ship trajectory. We are getting many questions from clients about Bitcoin and its legitimacy as an investment. The simple question people are asking is, “Should I buy Bitcoin?” The answer is not as simple as the question, so I thought it would be a good idea to share our thoughts on Bitcoin with some context.
What is Bitcoin?
Bitcoin is decentralized software based currency that started in 2009. Bitcoin has no physical presence and is not backed by a central government or monetary system. Bitcoin is one of 1,324 crypto-currencies that exist. It is the largest and was the first crypto-currency. There are currently 17.4 million Bitcoins in circulation. Bitcoin’s original function was to facilitate digital transactions. As a currency, Bitcoin functions with no rules or regulation.
Is buying Bitcoin an investment or a speculation?
The main difference between investment and speculation is the amount of risk taken in the trade. High risk trades that are made in hopes that something will go up are speculative and trades based on analysis and fundamentals are an investment.*
It makes sense to consider Bitcoin similar to a commodity. The price of any commodity, like gold or oil, represents both the intrinsic value and the speculative value. The intrinsic value can be described as the amount of value of the commodity’s price based on only the industrial need. The speculative portion of the value represents all of the purchases of the commodity by people who aim to profit from an increase in the value of the commodity. The most important thing to understand is that the speculative portion of the value can be eliminated almost instantly. That being said, the more of a commodity’s value that is made up of speculation, the more risk there is in the trade.
In late 2008, oil was on a tear, reaching record prices. Oil was trading at about $127 per barrel. There was talk that the price would go higher and higher. Goldman Sachs had a price target of $200 by the end of the year. Analysts urged caution as they estimated that almost 75% of all oil purchases were speculative and not for industrial purposes. Short story shorter … within months, oil was trading at $32 per barrel, just 26% of its high. The entire speculative trade vanished, leaving only the intrinsic or industrial value remaining.**
Fast forward to Bitcoin. As of the day of this writing, Bitcoin notched a price of over $19,000 per coin representing a year-to-date gain of over 1,900%.† Bitcoin is all the rage to say the least. The phrase “everybody and their mother is talking about Bitcoin” can be taken literally. While nobody can explain why the crypto-currency is experiencing a meteoric rise, they certainly want to be part of it. It is nearly impossible to track Bitcoin purchases. The lack of supervision is basically the point of Bitcoin. While we cannot with good accuracy pinpoint the intrinsic or industrial value of Bitcoin, we can understand that the amount of Bitcoin needed to facilitate digital transactions that are unable to happen in the absence of the digital currency would represent Bitcoin’s intrinsic value. Sure, you can buy a $100,000 Tesla automobile with Bitcoin, but there are two reasons I can imagine one would want to do that. First, it’s kind of sexy to walk in to buy an expensive car with the latest tech super-fad, Bitcoin. Nothing like passing up the finance desk of shame and opting to pay with crypto currency, putting your entire financial and tech status on full display. Second, the IRS views Bitcoin as an asset, not a currency, so using the Bitcoin in a transaction clouds the money trail making it hard for the IRS to tax the gain as capital gains. So, yes, there are some real reasons Bitcoin has real industrial value, but ask yourself this question: Is everybody (and their mother) clamoring to buy Bitcoin (thus running up the value of Bitcoin) because they are in desperate need for a digital currency to make an online transaction that Visa or MasterCard just can’t handle? No, they are buying it because they want to make money as the value of Bitcoin skyrockets. I would be confident suggesting that Bitcoin’s industrial value may not be more than 5-10% of Bitcoin’s total value, making the speculative portion of Bitcoin’s value possibly over 90%. Do I sound crazy? Let’s assume that at the beginning of 2017, there was no speculative presence in Bitcoin (which certainly wasn’t the case) and the $957 price was entirely industrial value. If we assume all of this year’s growth (1,900%) was driven by speculation, then 95% of Bitcoin’s value would be because of speculative buying. With those numbers in mind, anybody buying Bitcoin should understand that 95% of Bitcoin’s value could evaporate tomorrow in the event people stop buying it because they think it will keep going up. My direct advice to anybody thinking about buying Bitcoin or anything else speculative: Don’t use any money that you can’t afford to lose tomorrow. That doesn’t mean I don’t think Bitcoin will continue it’s path and it isn’t a predication of catastrophe, it is simply calling it what it is: an extremely speculative trade by any standard.
Tax Issues surrounding Bitcoin – always thrilling, read on…
With Bitcoin’s massive rise over the last few years, people have made a lot of money. Since the IRS views Bitcoin as an asset, not a currency, any realized gain is taxed at the individual’s capital gains rate. This is obvious if you buy and sell Bitcoin, but what gets tricky is if you make a purchase using appreciated Bitcoin. Let’s say I buy $5,000 of Bitcoin in January 2017; in December of 2017 I use those same Bitcoin to purchase a $100,000 Tesla. Technically, I have a realized short term capital gain of $95,000 (the short term rate is 25%). The gain could also disqualify me from certain tax credits and deductions. Since the transaction is not reported, there is no 1099 of sorts. If you knowingly do not report the gain, you are committing tax evasion. Remember, the IRS views Bitcoin as an asset, not a currency.
According to a recent article on Forbes.com, the IRS won a lawsuit against Coinbase, one of the largest Bitcoin exchanges, requiring it to turn over records relating to users.†† Coinbase alone has over six million customers. Last year only about 800 people in the United States acknowledge gains from Bitcoin transactions on their tax returns. For your reading enjoyment, I’ve included the IRS posting regarding Bitcoin:
IR-2014-36
The notice provides that virtual currency is treated as property for U.S. federal tax purposes. General tax principles that apply to property transactions apply to transactions using virtual currency. Among other things, this means 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. ‡
Technical Risk and Dilution – words like codebase, cryptography, and others you don’t understand
Remember, Bitcoin is a digital currency based on software. Bitcoin was created by Satoshi Nakamoto who was in 2016 revealed to be Australian entrepreneur Craig Wright. It was created as an open source project. There is no Bitcoin company and there really is no “they.” While there are currently 17.4 million Bitcoins in circulation, there is a theoretical cap of 21 million Bitcoins. New Bitcoins are created by people solving complex Bitcoin algorithms that help maintain and secure the Bitcoin network. This practice is called “Bitcoin mining.”
It is important to understand that there are no rules with Bitcoin other than those originally established in the code when it was created. There is no governing body. “Bitcoin has value because a community believes it has value,” said Christian Catalini, who studies bitcoin and other cryptocurrencies at MIT. “This is not unlike other forms of currency through history. With bitcoin, you are replacing trust in the solvency of a government and its institutions with trust in the codebase, cryptography, and incentives used to run the decentralized network,” Catalini added.
One day there was no Bitcoin, and then next day there was Bitcoin. Today there is a theoretical cap on the amount Bitcoins that can exist, tomorrow maybe the cap is higher, who knows? Any increase in the supply of Bitcoins would decrease the value of existing Bitcoins and seriously jeopardize any legitimacy of the currency. Also, with other digital currencies popping up (there are 1,324 other digital currencies) there could be significant competition for the speculative dollars chasing Bitcoin.
Final Thoughts on Bitcoin
I cannot stress enough how important it is to understand the risk involved with a speculative investment like Bitcoin. At HD Wealth Strategies we take great care to protect and grow our client’s hard-earned money. The decision to buy Bitcoin or engage in any other speculation is not a binary decision. You have to consider your own financial situation. If you have money to risk that you won’t miss and you are seeking a thrill one way or another, maybe a purchase of Bitcoin is for you. However, if you can’t afford to laugh while losing money, if you don’t have an exceptionally astute understanding of technology, or if you get startled by the sudden reality of gravity, you should steer clear of Bitcoin.
*Source: https://www.investopedia.com/terms/s/speculation.asp
**Source: https://finance.yahoo.com/quote/CL%3DF
†Source: https://finance.yahoo.com/quote/BTC-USD?p=BTC-USD
‡Source: https://www.irs.gov/newsroom/irs-virtual-currency-guidance
Other Sources:
Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through HD Wealth Strategies, a registered investment advisor and separate entity from LPL Financial. LPL Financial does not condone or endorse the discussion of or investment in Bitcoin. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial advisor and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.
