ABC’s of Crypto
ABCs of Crypto ….cryptocurrency can be complicated for the average person. Add income tax regulations an it can all be overwhelming. This will be a useful guide for those who want to understand crypto and associated taxes that affect crypto transactions.
Derived from the words alternate and coins. All coins except for Bitcoin and Ethereum are considered altcoins. There are thousands of altcoins in the market.
Free coins or tokens sent to a wallet with no expectation of anything in return from the receiver. A gift of free coins to a wallet from an airdrop is considered taxable income to the receiver. An airdrop can also occur after a hard fork.
Buying crypto in one exchange and selling it on another exchange for a profit based on different price points. Because crypto is considered property, then capital gains or losses are reported depending on the gain or loss on the sale of the crypto.
When the drop in price of assets such as cryptocurrency, stock and other assets collectively fall and is greater than 20% from recent highs, it’s a bear market
A decentralized digital currency created by Satoshi Nakamoto. The first widely adopted cryptocurrency allowing users to directly send digital money on the internet and record transactions on a blockchain.
When cryptocurrency, stock and/or other asset values collectively rise.
A ledger of transactions that can be viewed and verified by any user as an open alternative to centralized middlemen such as banks and credit card companies. Blockchains are global, increase privacy through pseudo-anonymous transactions and are open sourced.
Buy the Dip (BTD)
Buying crypto when the price is believed to be bottoming out after a downturn prior to rising again.
Centralized Exchanges (CEX)
Retail application such as Coinbase and Crypto.com. Used to trade crypto for fiat, fiat for crypto, or crypto for crypto. Coin selection can be limited
Self-custodial wallet whose access is kept on a physical device not connected to a computer or internet most of the time.
Short for cryptocurrency – a digital or virtual currency whose transactions are recorded on a blockchain. Also referred to as a coin.
The owner of a digital currency wallet, such as a user or a centralized exchange such as Coinbase.
Decentralized autonomous organization (DAO)
An online community with no central authority founded to achieve a common goal with decisions made via group consensus. How are DAOs taxed?
Not clear as some speculate it may be taxed as a corporation. However, if they are considered a pass-through entity, then any income received would be taxable to the investor.
Decentralized exchange (DEX)
Crypto trading platform with no single entity or individual controlling access. Users can connect a self-custodial wallet to a DEX and enjoy lower transaction fees than on CEXs. Third-party hacking of DEXs may result in irreversible theft.
Decentralized finance (DeFi)
Umbrella term for peer-to-peer financial services recorded on public blockchains. DeFi is primarily used with Ethereum. DeFi cuts out the middleman of traditional banking and other financial services and products.
Income from DeFi – such as earning interest is taxable income. Other transactions include borrowing, lending, trading derivatives, trading assets, buying insurance, etc.
Any uniquely identifiable, valuable digital creating with discoverable and verifiable ownership. This includes photos, manuscripts, documents, digital coins or tokens and NFTs. This term will be used by the IRS beginning with the 2022 tax year.
Distributed ledger technology (DLT)
Form of recording, sharing, and synchronizing information such a transactions or contracts across multiple websites or applications.
Securing data to prevent sensitive or private information from theft or unauthorized use.
2nd largest crypto behind BTC. ETH was not created to be a digital currency, but as a decentralized means of trading, investing, lending, borrowing, & engaging in other DeFi activities. There is ETH 2.0 which is supposed to be a major upgrade.
Platforms where users can purchase, sell, or exchange crypto. They can be centralized or decentralized.
Currency associated with Ethereum
Any currency declared legal tender by a national government that is not backed by a physical commodity such as gold or silver
“Fear of Missing Out” – Individual and institutional investors may experience euphoria during a crypto bull run and fear missing out on opportunities to profit.
When a cryptocurrency community changes the rules governing transactions involving that coin and the code involved due to an agreed protocol change or due to a major hack
Abbreviation of “fear, uncertainty, and doubt.” Bad information seeded to investors to make them sell prior to a bull run. The actors spreading FUD are usually mainstream media pundits and social media naysayers
An asset that can easily be exchanged for something of similar value inlcuding currencies, stocks, mutual funds, and crypto
Going to the moon 🌔
Users liken the rise of crypto prices to a rocket headed towards the moon
Fees paid to the Ethereum network to use the system which are paid in Ether or the native crypto of Ethereum
The permanent split of a blockchain where new rules and code (called consensus protocols) are used and older consensus protocols are no longer used, effectively creating a new blockchain. A hard fork creates new tokens to be used in the new blockchain.
Abbreviation for “hold on for dear life,” originally an accidental misspelling of “HOLD.” HODLers buy and hold cryptocurrency regardless of price fluctuations, in most cases.
Holding the Bag
Refers to users who own a cryptocurrency whose value plummets to or near zero. This was similar to Bear Stearns investors during the 2008 stock market and housing market crash when the company filed for bankruptcy, closed down, and left investors with nothing.
Software-based crypto wallet that is always connected to the internet. Because a hot wallet is online, it is easier to store, send and receive tokens, but it’s also easier to get hacked and vulnerable to online attacks.
Initial Coin Offering (ICO)
Where a crypto business tries to raise funds through an ICO. Investors provide funds in return to receive a new calling or token issued by the crypto business.
Similar to an Initial Public Offering (IPO) of a stock.
JOMO (Joy of Missing Out) – different from FOMO. Someone relieved he or she missed out on the crypto craze of 2021, especially after the fall in token prices.
KYC (Know Your Customer) – Used by banks and financial institutions to prove a customer’s identity as part of the Anti-Money Laundering (AML) regulations. Cryptocurrency exchanges also require KYC to comply with AML regs by verifying a customer’s identity. Additional documentation may be required to verify your identity in order to transact on crypto exchanges.
Keylogger – Software used to monitor and collect keystrokes typed. Criminals will use this to steal sensitive information (from hardware or software) from unsuspecting users to capture crypto exchange passwords or collect private keys from their crypto wallets.
Laser Eyes – Bitcoin investors and proponents who signaled their support on Twitter by putting lasers on the eyes of their profile picture.
Ledger – Record keeping system of financial transactions that cannot be changed. There is no central authority and others cannot see the identity of the two parties transacting.
Liquidity Pool – According to ZenLedger, a liquidity pool is a smart contract where crypto users’ funds are grouped together to provide liquidity for executing trades. Rewards earned from liquidity pools are subject to income tax. Crypto for crypto trades are subject to capital gains taxes.
Memecoin – Coins created based on memes. The most popular meme is Dogecoin (DOGE), named after the doge dog meme. After DOGE gained popularity, SHIBA INU, AKITA, and Dogelon Mars (ELON) followed.
MetaMask – An app- and internet browser-based wallet from which users can buy, store, send, and swap cryptocurrencies and NFTs. Users can connect their Metamask wallet to both centralized and decentralized exchanges.
Minting – Publishing an NFT or creating a new cryptocurrency or individual coin, recorded on a blockchain for storage, trade, or purchase. Minting or creating your own NFT is not taxable. However, minting costs can be added to the basis of the NFT. Selling an NFT after minting is subject to capital gains tax.
Mining – Verifying transactions on the blockchain and generating new coins. Miners are rewarded with additional coins. If mining as a business, it is subject to income and self-employment taxes. If it’s a hobby, it would be reported as other income on the tax return.
Node – Any computer dedicated to supporting a cryptocurrency network by running blockchain software to validate and relay transactions.
Non-Fungible Asset – An asset that cannot be broken up and sold in fractional shares, i.e., pieces. A non-fungible asset cannot be copied, substituted, or reproduced such as real estate or art.
Non-Fungible Tokens (NFTs) – A non-fungible digital asset with unique characteristics. Art, music, digital sports memorabilia, in-game items, and videos can be “minted” as NFTs.
Not Going to Make it (NGMI) – Using poor judgment in crypto, investing, and life decisions indicating someone will fail or face severe consequences like eating bugs for protein.
Not Your Keys, Not Your Coins (NYKNYC) – A common saying among decentralized exchange users who prioritize self-custodial wallets. All decentralized and many centralized exchanges have no coverage from the United States Federal Deposit Insurance Corporation (FDIC). If an exchange loses a user’s coins, that user has no deposit coverage, meaning the coins the user held in that account are gone without hope of recourse. It is recommended that all coins purchased be transferred to a self-custodial wallet, preferably with cold storage.
Off-Chain Transactions – Crypto transactions that occur off the blockchain. An example includes swapping private keys to an existing wallet instead of transferring funds. These have lower fees, immediate settlement, and greater privacy. All off-chain transactions are eventually recorded on the blockchain.
On-Chain Transactions – Transactions that occur and are recorded on the blockchain. On-chain transactions have more security and transparency.
Peer-to-Peer Network – An exchange of crypto between two parties without a central authority. This provides more privacy than traditional online transactions because the transactions are anonymous. Can occur on DEX or CEX.
Private Key – A secret key used to encrypt and decrypt sensitive data. A private key is shared between the sender and receiver of the encrypted data.
Proof of Stake (PoS) – A validation method to confirm transactions with validators chosen based on a set of rules spending on the stake they have on the blockchain. Proof of Stake uses less energy compared to Proof of Work and was created as an alternative to Proof of Work. The next block writer on the blockchain is randomly selected, with nodes more likely to be chosen with larger stake positions.
Proof of Work (PoW) – A validation method to confirm transactions on the blockchain through mining. In mining, an individual performs cryptographic transactions to verify connections between and among the wallets involved in those transactions. Proof of Work requires much energy to validate transactions and create new tokens.
Public Key – Use of cryptographic code to facilitate transactions between parties, verifying signatures and encrypting data.
Pump and Dump – When a user or users pumps or promotes a coin to artificially inflate its per-coin value only to sell off before the coin price drops. Pump-and-dump groups organize on social media to buy a coin (to pump the price), thereby creating false demand and therefore FOMO among individual investors unaware of the scheme.
Quantum computing – development of computer based tech using principles of quantum theory. Think Ant Man.
ABCs of crypto starting with the letter R
Rekt – When a cryptocurrency owner’s personal finances are wrecked from a large, unmanageable, or unforeseen crypto loss.
Rugged – Falling for a crypto scam
Smart Contracts – Establishes the terms of an agreement between two parties on the blockchain through a self-executing contract written into lines of code.
Soft Fork – A change to a cryptocurrency’s rules and code where the nodes do not upgrade to the newer software. The older software protocols are still valid, and no new coins are created.
Stablecoins – Digital currencies pegged to a stable reserve asset, like the US dollar or gold. Stablecoins are designed to reduce crypto volatility. Another benefit is to be able to use it globally. This was done to avoid the wild pricing swings seen in Bitcoin up to that time.
Tether, USD Coin, DAI, Binance USD, Pax Dollar, and Digix Gold Token (DGX) are some stablecoins. The USDC (United States Digital Coin) is a stablecoin pegged to the US Dollar
Staking – Locking up your crypto such as ETH, Cardano, and Solana in an account that allows staking. Users receive rewards by earning an interest rate.
Although coins in a staking pool are still in users’ possession, there may be a waiting time (days or weeks) before they can withdraw their staked, interest-earning crypto. Rewards earned by staking are subject to income tax.
Swap – A trade from one cryptocurrency to another without fiat currency involvement, i.e., BTC for ETH. A swap of one crypto for another is subject to capital gains tax based on the value at the time of the swap of the old coin minus the cost basis of the old coin.
Token – Another word for cryptocurrency. Used for other crypto besides Bitcoin and Ethereum. Token examples include NFTs (non-fungible tokens), governance tokens, and DeFi tokens such as Maker, Compound, Uniswap, Aave, and Chainlink
Utility Token – A token that has a specific use case. Mostly created on the Ethereum blockchain. Utility tokens allow users to perform some actions on a specific blockchain network or decentralized application.
Validator – Someone who is responsible for validating transactions on the blockchain.
Vitalik Buterin – Programmer and creator of Ethereum
Wallet – A cold storage device or application that stores crypto keys and allows their owner to access their coins. Wallets contain both a public key (wallet address) and a private key in order to sign crypto transactions. A wallet allows users to send, receive, and spend crypto.
Web 3.0 – Community-based internet known for peer-to-peer transactions and DAOs. Contracts exist on the blockchain for crypto transactions, for example, and for creators selling their art or music without relying on a distributor or record company. Web 3.0 is differentiated from Web 1.0 and Web 2.0, known for a steep learning curve to use and for privacy-violating social media companies, respectively.
We’re All Going to Make It (WAGMI) – Celebration from the crypto community indicating they will be successful in the future.
Whale – Individuals, institutions, or exchanges that own much crypto. A user who owns 1,000 or more Bitcoin (BTC) is considered a whale, for example.
XRP – A cryptocurrency (or digital currency) with transactions that happen faster than BTC or ETH. It is a native token of Ripple, founded in 2011.
Yield Farming – Lending your coins on a DeFi protocol to earn more coins, interest, and fees. Income is reported on the tax return on the coins, interest and fees earned on your return.
Zero Confirmation Transaction – An unconfirmed transaction. Could also refer to an exchange that has not been recorded or verified on the blockchain.
You can read more about cryptocurrency and taxes in my book, The Crypto Tax Book available on Amazon