The ownership of a digital currency, whether it be bitcoin or any other cryptocurrency, has by its very nature significant complexities. As part of its inherent complexities, the issue of its taxation and how one can legally dispose of the cryptocurrency upon one’s demise needs to be properly addressed.

In spite of most references to bitcoin or other cryptocurrencies as being a “digital currency,” the IRS in Notice 2014-21 issued on March 25, 2014 made it clear that for purposes of federal taxation in the U.S., bitcoin is to be treated as “property.” Thus, like all other forms of “property” the principles of taxation that apply to property transactions apply to the transactions involving cryptocurrency. Thus, income taxation, short- and/or long-term capital gains and/or losses and their attendant tax rates need to be applied to transactions involving bitcoin or any other cryptocurrency. The use of a cryptocurrency to purchase goods and services has the potential for income taxation, or losses, as there could be income taxes due on the difference between the value of the cryptocurrency at the time it was purchased, and its fair market value when spent on goods or services. This taxation could also occur when it is converted into U.S. dollars.

Because cryptocurrency is treated as property by the IRS, extensive and detailed record keeping is needed. The failure to adequately keep records of all transactions could potentially come back to haunt one’s family and estate if contemporaneous records are not kept and income taxes paid on the transactions annually.

On the positive side, upon the death of a bitcoin or other cryptocurrency holder, the beneficiaries of said cryptocurrency will receive the cryptocurrency at its fair market value on the holder’s date of death (Section 1022 of the Internal Revenue Code). Their cost basis is stepped up to its date of death value as it is includible like any other property in the decedent’s taxable estate, subject to federal and state estate tax laws and their applicable estate tax credits.

Because of its digital nature there is no tangible documentary evidence of the cryptocurrency’s existence. There is no bitcoin bank statement. In essence, its owners engage in direct transactions with each other. There are more than 100,000 merchants that accept bitcoin as payment. As of the date of this writing, one bitcoin is worth approximately 6,600 U.S. dollars. The transactions in bitcoins are recorded in a publicly distributed database which is known as a “blockchain.” The blockchain is constantly and regularly updated. It is in the blockchain where the bitcoin exist.

The name of the bitcoin owner is not publicly recorded, but, one’s ownership is tied to a specific bitcoin address. This is where the potential problem exists for not only the holder, but, his or her heirs. One’s bitcoin address can only be accessed by the holder of its two (2) digital keys. One key is public and the other is private. The problem exists if the private key is lost, there is no way to access the bitcoin holdings. Generally, both keys are stored in a digital wallet by the holder.

Because bitcoin or other cryptocurrency is treated as property, it can be distributed by one’s Last Will and Testament and be technically assigned/transferred to one’s Revocable and/or Irrevocable Trust. This would require that the Trust be the holder of the bitcoin in the blockchain. Even if one’s heirs, executor(s), and trustee(s) know of the existence of the bitcoin, however, if they do not know of both digital keys, bitcoin cannot be accessed and distributed to one’s beneficiaries. It would be for all practical purposes forever lost in the blockchain.

This problem is unfortunately similar to that facing the owners of all types of digital assets. One’s passwords, keys, etc. must be divulged to one’s family and those tasked with handling one’s affairs. This problem of knowledge of two keys (both public and private) is also a dilemma if the bitcoin holder is suddenly taken ill or is incapacitated. The named agent under his or her Power of Attorney would not be able to access the bitcoin without knowledge of the private key; and if the Power of Attorney does not refer to digital assets.

Because of the volatile nature of bitcoin and other cryptocurrencies it is imperative that the executor/trustee of an estate and/or trust beware of its volatility and take all necessary steps to seek to comply with the Prudent Investor Act and diversify the holdings in the Trust and/or estate. Even ownership of just a little bit of bitcoin can end up creating headaches. In conclusion, the ownership of a cryptocurrency has a number of potential pitfalls.