Bitcoins: How do they work?

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Bitcoins: How do they work?

By Thomas C. Pavlik, Jr.

Although Bitcoins have been around since 2009, it is only recently that they have been all over the news. Most of us understand that Bitcoins are basically Internet cash, but beyond that there seems to be confusion and misunderstanding.

Bitcoin is a digital currency. Rather than coins or paper bills, Bitcoins consist of a discreet Internet code that can be stored online or on your computer hard drive. Safeguards allegedly exist to prevent forgery and the total supply of Bitcoins is capped at 21 million units. Currently, there are approximately 12,500,000 Bitcoins in circulation.

Conventional currency is created by central banks.  Bitcoins, on the other hand, are created as people “mine” Bitcoins by using computers to solve increasingly complex math equations. Twenty-five Bitcoins are “awarded” every 10 minutes.

No central authority sets the value of Bitcoins. Because supply is capped, the value of a Bitcoin is (or more properly will be when all 21 million are in circulation) set by demand alone. Various computer exchanges exist that set the market for Bitcoin value. As of the writing of this article, one Bitcoin is worth approximately $625. Last fall, the value of a Bitcoin approached $1,200.

For many, the appeal of Bitcoins lies in the fact that, much like the Internet itself, this is a completely open financial network. Banks aren’t involved nor is there any central authority. The hope is that much as the Internet has led to the creation of new paradigms, that Bitcoin will lead to a whole new world of financial services that are not tethered to the world’s existing financial structures. In short, you get to make your own rules.

A growing list of merchants is now accepting Bitcoins as a valid method of payment. Overstock.com and more than 10,000 other merchants now accept Bitcoins. Currently, most vendors immediately convert their Bitcoins to local currencies via one of the many Bitcoin exchanges. Speculators and investors, however, may hold on to Bitcoins in the hope of long-term appreciation or may “day trade” in the hope of short term gains.

Why, you ask, would someone want to accept Bitcoins?

First, an increasing number of transactions (and virtually all online transactions) are made by credit card or Paypal. Each time a merchant engages in such a transaction the credit card company gets a percentage of the purchase price – three percent on the average. With Bitcoin, there is no “middleman.”

Second, a certain segment of the population is drawn to the anonymity offered by Bitcoin. Other than the unique identifying code, there is no way to trace a transaction. For those that prefer not to draw the attention of the authorities (think illegal transactions) or for those who prefer anonymity (online gambling, for example) Bitcoins might be an attractive option.

Third, since Bitcoins are not part of the traditional monetary system, many believe that Bitcoin transactions aren’t subject to tax. More on that in a moment.

Finally, many people simply believe in the creation of an alternate monetary system that cannot be controlled and manipulated by central banks and other governmental authorities. In short, they believe in the democratization of the financial world and analogize Bitcoin to the early and unwieldy days of the Internet – think of how far we’ve come since then.  Time will tell.

Why might you want to avoid Bitcoins?

First, although the value of Bitcoins has been steadily increasing, there has been substantial volatility in Bitcoin value.

Second, there are security and reliability risks. If you store your Bitcoins online you are at risk of being hacked. Or, as perhaps you may have seen recently in the news, of having your storage server go out of business. If you store your Bitcoins on your hard drive you might forget your password or have the Bitcoins corrupted by a virus. Think of the poor guy who accidentally threw away his hard drive containing Bitcoins worth hundreds of thousand dollars. Plus, unlike most bank accounts, there’s no FDIC insurance coverage.

Third, transacting in Bitcoin does not mean you don’t owe taxes. The courts have long held that “barter” transactions count as income. For example if I barter legal services for home repair services, the value of the home repair services I receive counts as taxable income. Although the IRS has not addressed the issue yet, in all likelihood the value of Bitcoins received in a transaction will be counted as income for tax purposes.

In addition, if I buy a Bitcoin for $600 and sell it for $1,200, the $600 profit constitutes gain that is subject to tax. Even though there may be no authority to report the transaction or the resulting gain, the law requires you to report that gain on your tax return.

Bitcoins emergence and increasing acceptance is exciting to watch, but before jumping in the deep end do your homework and proceed with some caution.

Thomas C. Pavlik, Jr. is an attorney from Springfield.

By |March 26th, 2014|Categories: Article|0 Comments

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