Risks & Rewards of Buying Bitcoins – tax implications

Play the Markets: The fastest—but riskiest—method is to go straight to the markets. So, say, for Mt. Gox, the reputed “world’s oldest and largest Bitcoin exchange,” you first have to sign up, create a user name and then respond to the confirmation your email verifying your address.

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Then the system will ask that you scan and send confirm your real address and residence there for the last six months, and provide a government-issued photo ID. You will not however, have to include sensitive information such as your SSN.

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Then it’s simply a matter of depositing funds into your account and carefully watching the market for opportunities to make money. Like any exchange, Mt. Gox does charge a fee on your transactions, ranging from .60 percent per trade down to .25 percent per trade, which the company uses to support the business as a whole:

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But, once again, be warned. Just because it’s a digital currency doesn’t mean you won’t lose real cash money trading in it. And given that the current Bitcoin market is more volatile than a bag of plutonium nitrate, multi-explosive, sound seeking projectiles, you stand a very good chance to lose a lot of money, especially if this is your first foray into day trading. So unless you have cash to burn or you’re already a grizzled day trading veteran, you might want to take one more look at mining after all.

Risks and Rewards

So that’s how you make your foray into Bitcoin. It’s important, though, to first ask yourself if you really want to in the first place.

For conventional currency markets trading in the monies of stable, profitable countries, the fluctuations within the value of each currency is measured in fractions of a penny. Bitcoin values, on the other hand, rise and fall dramatically throughout each trading day, jumping in whole dollar amounts. This means that if you don’t have your act together and place a transaction order at the right time, you will lose magnitudes more cash than you would have trading dollars for yen. The value of Bitcoin as a whole, for example, dropped more than 50 percent over the 36 hours after China banned the cryptocurrency. A lot of speculators lost their shirts during that day. And it will almost certainly happen again.

What’s more, unlike traditional arbitrage play, the inherent volatility of the BTC market all but forces investors to offload their coins as quickly as possible to avoid getting caught in a crash. However only when investors hold onto their digital commodities for longer periods of time will the market actually stabilize. It’s a catch-22. And without commercial institutions like banks, which have huge reserves of liquid capital they can rely on, individual investors often can’t afford to just sit on their Bitcoin and wait for a rainy day.

Conversely, if one were to take the super-long view and, say, bought a few shares in 2012 at a sub-$100 price point, even with Bitcoin dropping half its peak value, that investor would still theoretically make over a 600 percent return on his investment just by waiting. Granted, the sub $100 days are likely now over, what with the currency’s new-found stardom so we’ll have to wait and see how the market plays out.

Even those big hits, though, come with big tax implications. As Forbes contributor Cameron Keng points out:

Bitcoin is taxable, whenever a taxable event occurs. A taxable event is whenever you cash out your bitcoin for any fiat currency (dollars, euros and etc.) or when you trade a bitcoin for anything (bartering). In taxation, bitcoin is best understood as an “asset.” Whenever you hold an asset, it can increase or decrease in value. When you trade the bitcoin for fiat currency, then you’re trading an asset for dollars. It works the same way as when you trade gold bullion for dollars.

Bartering or exchanging bitcoins for anything is also a taxable event. For example, Bob trades 1 bitcoin for a year’s worth of hugs. Bob traded or bartered 1 bitcoin for a year’s worth of hugs or a service. This is a taxable event. The same is true, if you traded 1 bitcoin for a tangible or intangible object. This even applies if you’re trading 1 bitcoin for another bitcoin.

Simply put, if Bitcoin is to be treated like legitimate currency, it’s going to be taxed like legitimate currency.

Nor should you assume that your Bitcoins are completely secure either. As Mark Vankempen, senior advanced R&D engineer at LogRhythm, explained to the IT Business Edge:

A BTC wallet is like a real wallet filled with cash. You should never keep all your eggs in one basket and the BTC wallet is no different from this age old idiom. So far there is no air tight solution to keeping your BTC safe and secured…the following action items that can help protect your BTC investment: Backup and encrypt your wallet, make multiple copies of your backup, store them in more than one secure location and finally, don’t keep all your BTCs in one wallet.

Don’t pull a Bitomat.pl. This former mining company lost 17,000 BTC (worth about 14.5 Million USD) during a routine maintenance restart when the server hosting the company’s digital wallet ate itself.

The Bitcoin’s meteoric rise in value and the relatively low risk of being caught stealing it have also combined to make the currency a huge target for cyber criminals. Smaller online exchanges that have skimped on security systems can be hacked. The Sheep Marketplace, for example, had 96,000 Bitcoins (worth $220 million) stolen earlier this year, as did GBL andTradefortress. Criminals also routinely target internet-connected computers that store individual Bitcoin wallets, attacking them with everything from malware and phishing tactics to old-fashioned social engineering. And as recently as last November, thieves stole nearly a million dollars worth of Bitcoin from Bitcoin Internet Payment System (BIPS), a Denmark-based Bitcoin payment processor.

In short, even if you trade Bitcoin brilliantly, you’re still susceptible to giant losses the good ol’ fashioned way: theft.