personal finances — May 11, 2018

Should You Care About Bitcoin?

by Ryan Norton

A woman researching Bitcoin

We’ve all been there. Your tech-savvy friend sends a Facebook message warning that you’re about to miss the once-in-a-lifetime investment opportunity—all you have to do is get into the Bitcoin market right now. After hearing your pal wax poetic about “democratizing finance” and “lifting up third-world economies,” you decide to look into it.

OK, maybe that was just my experience.

Even if someone hasn’t spent hours texting you about Bitcoin, perhaps you read an article predicting its untimely end—after all, Bitcoin’s value dropped by more than 50% at the end of 2017. No matter how you heard about it, you may want a neutral answer to the question: “What is Bitcoin?”

Without getting too deep in the weeds, let’s take a brief look at one of the most polarizing financial developments of the last ten years.

What is Bitcoin?

Bitcoin is a virtual currency based on an encrypted, publicly distributed ledger: hence “cryptocurrency.” (That explanation glosses over quite a bit, but should give you a basic understanding.)

Aside from the novelty of a completely digital currency, why should anyone care about Bitcoin? To answer that, we first need to think about credit cards and the transaction fees charged to merchants.

What are credit card transaction fees?

When Walmart accepts your credit card as payment for a new smartphone, the credit card company charges Walmart a transaction fee, and in some states, that fee is passed along to consumers as a surcharge. The credit card company in this scenario is acting as a “trusted third party” whose job is to verify the transaction before issuing funds.

Banks and credit card companies justify these fees by highlighting the time and resources spent mediating transaction disputes, an all-too-familiar process for victims of credit card fraud. But some, like the pseudonymous creator of Bitcoin, believe the increased cost reduces the viability of smaller transactions in an online marketplace.

Prior to 2008, technological and consumer-trust limitations stymied potential solutions. That year, a cryptographic innovation made eliminating trusted-third-party transaction verification actually seem possible: the blockchain.

A couple researching Bitcoin at a coffee shop

What is blockchain?

Think of blockchain as another way of describing the publicly distributed Bitcoin ledger. After a group of transactions (a block) is verified, it’s added to the list of all previous Bitcoin transactions (the chain) and transmitted to thousands of computers across the world—all of which are dedicated to maintaining the ledger.

Since the encrypted record is simultaneously distributed to multiple independent computers, it’s considered a safe way to digitally store information: in other words, it establishes trust for Bitcoin users.

Let’s assume you’re a nefarious cybercriminal who wants to steal bitcoins by hacking into the most recently verified block of Bitcoin transactions. You’ll have to overcome two major hurdles before getting your hands on those bitcoins:

  1. Hacking the encryption on the newly minted block and all other blocks that have ever been verified and added to the chain.
  2. Convincing all the other computers on the Bitcoin network that your hacked copy of the blockchain is the real version.

In short, blockchain is very secure. And that security—that trust—is why many people consider Bitcoin and other blockchain-based cryptocurrencies a viable alternative to older digital payment methods.

Why doesn’t everyone use Bitcoin?

Since Bitcoin and other blockchain-based cryptocurrencies (it’s open source!) are digitally transmittable, secure, and seemingly eliminate the need for third-party transaction verification, why hasn’t everyone jumped on the bandwagon? If we ignore existential and market concerns, it comes down to something far more basic: The Internal Revenue Service doesn’t treat cryptocurrency as a currency.

The really short explanation is that the IRS considers Bitcoin and all other cryptocurrencies property for tax purposes, but even that isn’t exactly cut and dry. There are specific rules governing what kind of property cryptocurrency is based on how taxpayers consider the investment.

Another problem

When you exchange bitcoins for goods and services, you have to record their value at the time of the transaction. That means Bitcoin often occupies a space similar to stock investments, requiring meticulous record-keeping for those who would use it as currency.

Should I invest in Bitcoin?

Before developing any type of investment strategy, you should always do your homework and temper your expectations. Learn everything you can about the investment, and understand that jumping into something like cryptocurrency probably isn’t going to make you an overnight millionaire. If at all possible, sit down with a financial advisor who specializes in the type of investment you’re considering.

Even if Bitcoin is eventually tossed in the dustbin of history, it’s possible the technology upon which it’s based will have a longer shelf life. Financial institutions have been investing in their own blockchain products, resulting in new cryptocurrencies and other unannounced projects.

About the author

Ryan Norton is the editor for Taxing Subjects and a regular contributor to the GruntWorx blog.

Related posts:

The Blockchain, Not Just Part of Bitcoin
Bitcoin, Meet Bitcoin Cash
Is Bitcoin a Viable Currency?

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