Taxing Crypto 101: Revenue Streams

Everybody has probably heard at least one anecdote about a person buying a couple of bitcoins back in the early 2010s, forgetting them on a barely functioning USB stick, and waking up in 2024 to the realization that they might be multi-millionaires. These are fun stories, but they are as rare as winning the lottery. Nevertheless, over the years, individuals and organizations have evolved cryptocurrency interactions into a well-defined craft, establishing highly effective opportunities to generate revenue. In today’s blog, let's delve into some of the primary revenue opportunities. Understanding these better is a significant step toward improving and refining the collection of tax from cryptocurrency-originated income.

Trust in Traditional and Digital Currencies

Nowadays, most traditional currencies, especially the US dollar, are not tied to any physical asset. The US dollar was once backed by gold, but this is no longer the case. So why does the US dollar maintain its value? Because of trust. The US economy is trusted by Americans and foreigners alike. People believe that if they have US dollars, they will be able to exchange them for something of value.

The same concept of trust applies to cryptocurrencies. Back in 2008, Satoshi Nakamoto, the mysterious figure—or group of individuals—introduced a digital asset called "Bitcoin." Without diving into technical details, the cryptographic algorithm behind Bitcoin was strong enough to prevent fraud, which helped build trust.  

Additionally, a community began to form around this new concept. Various features of the system appealed to different audiences.

Those wanting to keep their finances under the radar—whether for legitimate or illicit reasons—were attracted by the anonymity that Bitcoin offered. Individuals and businesses denied services by the traditional banking system also found a lifeline; these could be businesses that were once bankrupt or individuals living in countries where they couldn't open a bank account. Finally, there were the tech geeks—early adopters eager to test out this new financial starship. Many of them were young and not yet bound by financial liabilities, able to take risks, yet also well-established financially, with spare funds for high-risk investments due to the rapid growth of the tech industry over the last two decades.

Capital Gains: The Original Revenue Stream

The adoption of Bitcoin is on the rise. From the US President-elect buying a hamburger in New York City using Bitcoin, to giant corporations investing heavily in it, Bitcoin's acceptance has grown significantly. Recently, new ETFs have been introduced, providing average investors an opportunity to benefit from the growth of cryptocurrencies by purchasing standard securities through the stock exchange, without the hassle of diving into the technical and financial nuances. All of this has earned Bitcoin the reputation of being a form of digital gold—a trusted asset that can preserve and potentially increase in value. In the US alone, 13% of the population already owns a bitcoin or a fraction of one.

This brings us to the first and most straightforward revenue opportunity for cryptocurrency owners: capital gains. Unlike the anecdotes mentioned earlier, today's investors are approaching this in a structured and deliberate way. By purchasing Bitcoin or similar digital assets with US dollars, holding them until the value appreciates, and then selling for a profit, investors can capitalize on these gains.

Ethereum and Smart Contracts

Like gold, which has not been used as currency since the end of the 19th century, Bitcoin alone was not enough for modern needs. New technologies utilizing the underlying technology of Bitcoin (the blockchain) emerged, providing further, more advanced capabilities.

One of the most prominent platforms offering these capabilities is the Ethereum blockchain, which features 'smart contracts.' A smart contract leverages the same strengths of blockchain technology—being distributed and secure against fraud—to not only represent assets but also enforce a set of rules. For example, a smart contract could stipulate: 'If I give someone a coin of type X, I am entitled to receive 10 coins of type Y.'

NFT Trading: A New Revenue Stream

Smart contracts can facilitate advanced trading. One prominent example is the trade of NFTs. NFTs, which stands for Non-Fungible Tokens, can be thought of more simply as 'digital art.' Like traditional art, digital art can be copied, photographed, or even plagiarized. However, for many people, owning the original piece still carries significant value. The same applies to digital pieces of art—while you can copy and paste them, having proof of ownership provides a sense of authenticity and belonging.

NFTs are often organized into collections, and popular collections can soar in value. Successful creators back their work with effective marketing, which further boosts the value of their pieces. Trading NFTs to generate revenue is straightforward: buy a one-of-a-kind digital asset, such as a drawing of a mutant monkey, for X, and sell it for 2X—keeping the difference as profit.

Staking: Validating Transactions and Earning Rewards

Another important aspect of Ethereum we haven't discussed yet is how transactions are validated and how trust is established. Without diving too deeply into the technical details, it’s important to note that every transaction is validated by someone elected and agreed upon by the network of blockchain users. In Ethereum, this election process is based on the amount of Ether that one holds and is willing to stake as collateral, effectively ensuring the validator's honesty. Validators are compensated for performing the validation, providing them with another revenue stream (which we'll discuss in detail in the next blog of this series).

How does a validator obtain enough Ether to participate? It's similar to how a bank operates. Banks provide savings accounts and offer interest in exchange for the money deposited, which the bank then uses. Ethereum validators do something similar: you can "stake" your Ether and earn an annual percentage yield (APY) for it. This is yet another way to financially benefit from cryptocurrency investments.

Summary

Cryptocurrencies like Bitcoin and Ethereum have evolved from being speculative assets to structured opportunities for generating income. From capital gains and NFT trading to staking rewards, the blockchain ecosystem offers diverse methods for creating value. Understanding these revenue streams is crucial for tax professionals and investors alike, as it helps them navigate the complexities of the crypto landscape and make informed decisions. As we continue exploring these opportunities, we'll delve deeper into specific revenue models and how they fit into the broader financial ecosystem in future posts.

Download IVIX’ 2024 Overview of Potential Tax Revenue in the US Crypto Market here.

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