Cryptocurrency: How Crypto Assets Work, Their Risks, Scams and Tax Rules
In Short
Cryptocurrency is a type of crypto asset, a digital representation of value recorded on a blockchain, that can be bought, held and transferred without a bank. It is commonly bought by people seeking speculative exposure who accept extreme price swings, possible loss through hacks or failed platforms, and IRS treatment of each sale as a taxable property transaction.
TL;DR
- For U.S. tax purposes, digital assets are property, not currency, so selling, trading or spending them can create a capital gain or loss [1].
- Brokers report digital asset sales on Form 1099-DA for transactions on or after January 1, 2025, with basis reported for certain transactions beginning in 2026 [1][2].
- Losing a private key, or a hack or bankruptcy at a custodian, can mean permanent loss of access [5].
- Spot bitcoin and ether ETPs trade on exchanges, but the SEC says it did not approve or endorse bitcoin and calls these assets highly speculative [3][4].
- Relationship investment scams, sometimes called pig butchering, often use crypto and are very hard to recover from [6].
Quick Facts
| Legal Reference | IRC §6045 (broker reporting); IRS Notice 2014-21 (property treatment) |
|---|---|
| Complexity | High |
| Setup Cost | Low to open an account; trading spreads, network fees and wallet hardware add up |
| Time to Implement | Minutes to open an account; ongoing record-keeping for every transaction |
| Illustrative Example | Illustrative example, not a projection. An investor buys a crypto asset for $5,000 and, eight months later, uses it to pay for a $6,000 purchase. Because digital assets are property, that payment is a disposition, and the $1,000 increase is a short-term capital gain taxed as ordinary income. If the asset had instead fallen to $2,500, the investor would have a $2,500 capital loss. Actual results depend on prices, basis records and tax rates. |
Key Numbers & Limits
| Item | Limit or Rule | Notes |
|---|---|---|
| Tax Treatment | Property, not currency | Sales, exchanges and spending are dispositions [1]. |
| Short-Term vs. Long-Term | Held one year or less is short-term; more than one year is long-term | Short-term gains are taxed as ordinary income [1][8]. |
| Form 1099-DA Gross Proceeds Reporting | Transactions on or after January 1, 2025 | By brokers that take possession of the assets, such as custodial trading platforms [1][2]. |
| Form 1099-DA Basis Reporting | Certain transactions on or after January 1, 2026 | Decentralized, non-custodial platforms are not covered by the final regulations [1]. |
| Digital Asset Question on Form 1040 | Yes or No answer required every year | Buying with dollars and holding, with no other transactions, is answered No [1]. |
| FDIC Deposit Insurance | Does not cover crypto assets | FDIC insures deposits at insured banks only [7]. |
| Spot Bitcoin ETPs | Listing and trading approved by the SEC on January 10, 2024 | The SEC stated it did not approve or endorse bitcoin [4]. |
What Is Cryptocurrency?
Cryptocurrency is a crypto asset: an asset issued or transferred using a blockchain or similar distributed ledger [3][5]. For tax purposes, the IRS defines a digital asset as any digital representation of value recorded on a cryptographically secured distributed ledger, which includes cryptocurrencies, stablecoins and non-fungible tokens (NFTs) [1].
Crypto assets are held through a wallet, which stores the private keys — passcodes — that control the assets, not the assets themselves. A private key cannot be changed or replaced, and losing it means permanently losing access [5].
Investors can hold crypto directly, through a trading platform that keeps custody for them, or indirectly through exchange-traded products (ETPs). On January 10, 2024, the SEC approved the listing and trading of a number of spot bitcoin ETP shares, while stating that it did not approve or endorse bitcoin [4]. Spot bitcoin and ether ETPs are exchange-traded commodity trusts registered under the securities laws but not under the Investment Company Act of 1940 [3].
The SEC's investor education office describes bitcoin and ether as highly speculative, with prices that can fluctuate widely and trading that has been substantially driven by speculation [3].
How Does Cryptocurrency Work?
- An investor buys crypto with dollars on a trading platform, through a crypto kiosk, from another person, or by buying shares of a crypto ETP through a brokerage account [3][6].
- The assets are held either in self-custody, where the owner controls the private keys and seed phrase, or with a third-party custodian such as an exchange [5].
- Every sale, trade for another crypto asset, or purchase of goods or services with crypto is a disposition of property that can create a capital gain or loss [1].
- Crypto received as payment, from mining or staking, or from certain airdrops is ordinary income at its fair market value when received [1].
- Custodial brokers report sales on Form 1099-DA; taxpayers report dispositions on Form 8949 and answer the digital asset question on their return [1][2].
The Good: What Are the Benefits of Cryptocurrency?
- Crypto can be transferred around the clock without a bank, which some people use for payments or transfers.
- Spot ETPs offer price exposure in a regular brokerage account without handling wallets or private keys, though the ETP itself is still subject to those custody risks [3].
- Long-term capital gain rates apply to crypto held as a capital asset for more than one year [1][8].
- Form 1099-DA reporting gives investors who use custodial platforms a record of proceeds, and later basis, to help with tax filing [1][2].
The Bad: What Are the Drawbacks of Cryptocurrency?
- Prices can swing widely in short periods, and spot ETP shares may not track the asset's price exactly [3].
- Every trade or purchase with crypto is a taxable event, so active use creates heavy record-keeping [1].
- Crypto held on a platform is not a bank deposit and is not covered by FDIC insurance [7].
- Crypto ETPs are not registered investment companies and lack the 1940 Act's valuation and custody requirements that apply to mutual funds and most ETFs [3].
- Transaction, spread and network fees can be high relative to the amount traded.
The Ugly: What Are the Serious Risks of Cryptocurrency?
- If a third-party custodian is hacked, shuts down or goes bankrupt, customers may lose access to their crypto assets [5].
- A lost private key or seed phrase, or a stolen cold-wallet device, can mean permanent loss with no one to call for a reset [5].
- In relationship investment scams, sometimes called pig butchering, fraudsters build trust online, show fake profits on legitimate-looking apps, and then demand fees or taxes before a withdrawal that never comes; the SEC warns that funds are often sent overseas and are hard to trace [6].
- Fraudsters also use AI-themed pitches and deepfakes of celebrities or officials, and some direct victims to buy bitcoin at a kiosk and send it to them [6].
- Unreported crypto income or gains can bring tax, interest and penalties; the IRS also warns of fake digital asset compliance letters, which are themselves a scam [1].
Who Uses Cryptocurrency?
Who It's Commonly Used By
- Investors who want a small, speculative position and accept that it could fall to near zero [3].
- People who prefer exchange-traded exposure through spot bitcoin or ether ETPs in a brokerage or retirement account [3].
- Technically skilled holders who manage their own keys in self-custody [5].
- Businesses and workers paid in crypto, who report it as ordinary income [1].
Who It's Generally Not Suited For
- Money needed for near-term bills or emergencies, given the volatility [3].
- Anyone approached by an online contact or new friend offering to guide their crypto trading [6].
- People unwilling to keep detailed basis and transaction records for taxes [1].
- Investors who cannot tolerate the possibility of a total loss through hacks, platform failure or lost keys [5].
What Are the Key Rules & Requirements for Cryptocurrency?
- Digital assets are property for federal tax purposes, and income from digital assets is taxable [1].
- Gains and losses on capital-asset crypto are reported on Form 8949; holding more than one year makes them long-term [1][8].
- Crypto received for services, mining, staking or similar activities is ordinary income at fair market value [1].
- Every Form 1040 asks whether the taxpayer received or disposed of a digital asset during the year [1].
- Custodial brokers file Form 1099-DA for gross proceeds on transactions on or after January 1, 2025, and basis for certain transactions on or after January 1, 2026 [1][2].
- Spot crypto ETPs register their offerings with the SEC and file a prospectus and periodic reports, available on EDGAR [3].
What Are Common Mistakes & Red Flags With Cryptocurrency?
- Someone met online or by an accidental text who offers to teach crypto trading or shares an insider opportunity [6].
- Being told to pay fees or taxes before a withdrawal can be processed [6].
- Pressure to buy bitcoin at a kiosk and send it to a wallet address someone else provides [6].
- Offers to recover money already lost to a scam or a platform bankruptcy in exchange for a fee or a private key [6].
- Social-media hype around a new token or memecoin pre-sale, a common setup for pump-and-dump schemes [6].
- Sharing a seed phrase or private key with anyone, including support staff [5].
- Treating crypto-to-crypto trades or purchases as non-taxable [1].
- A letter with a QR code asking to register crypto on an IRS compliance portal, which the IRS says is a scam [1].
Frequently Asked Questions
Is Cryptocurrency Taxed as Property or Currency?
Property. The IRS treats digital assets as property, so selling crypto, trading one crypto for another, or using it to buy something is a disposition that can produce a capital gain or loss, short-term if held one year or less and long-term if held longer [1].
What Is Form 1099-DA?
Form 1099-DA, Digital Asset Proceeds From Broker Transactions, is the information return custodial brokers use to report digital asset sales. Gross proceeds are reported for transactions on or after January 1, 2025, and basis for certain transactions on or after January 1, 2026 [1][2].
Did the SEC Approve Bitcoin?
No. On January 10, 2024, the SEC approved the listing and trading of a number of spot bitcoin ETP shares, and the SEC Chair stated that the agency did not approve or endorse bitcoin [4]. The SEC's investor education office describes bitcoin and ether as highly speculative [3].
What Is a Pig Butchering Scam?
It is a relationship investment scam in which a fraudster builds a friendship or romance online, steers the target into a fake crypto investment that shows false profits, and then blocks withdrawals or demands more money for fees or taxes. Money sent is frequently not recovered [6].
Sources
- Digital Assets — Internal Revenue Service
- About Form 1099-DA, Digital Asset Proceeds From Broker Transactions — Internal Revenue Service
- Exchange-Traded Products (ETPs) Providing Exposure to Bitcoin and Ether — Investor Bulletin — U.S. Securities and Exchange Commission (Investor.gov)
- Statement on the Approval of Spot Bitcoin Exchange-Traded Products — U.S. Securities and Exchange Commission
- Crypto Asset Custody Basics for Retail Investors — Investor Bulletin — U.S. Securities and Exchange Commission (Investor.gov)
- 5 Ways Fraudsters May Lure Victims Into Scams Involving Crypto Asset Securities — Investor Alert — U.S. Securities and Exchange Commission (Investor.gov)
- Understanding Deposit Insurance — Federal Deposit Insurance Corporation
- Topic No. 409, Capital Gains and Losses — Internal Revenue Service
Primary sources only: the Internal Revenue Code, Treasury regulations and official agency guidance. Read how Zentavos researches these reports.