Bitcoin

In short

I once watched a neighbor spend an entire Saturday trying to explain Bitcoin to his father, and by suppertime the old man only wanted to know where the money was kept. That is a fair question, and it is the right place to begin. Bitcoin is a digital money that no bank or government runs, and you hold it by holding secret keys, not by holding coins in a drawer. You can buy a small piece of one coin, so you do not need a whole one. You will pay fees to buy, to sell, and sometimes to move it, and you will owe tax when you sell or spend it at a gain. If you ever own any, write down your keys on paper and keep the paper somewhere safe. Never type those words into a website that asks for them. Bitcoin can fall hard and fast, so only money you could lose without losing sleep belongs near it.

The whole of it

What it is

A friend of mine once asked whether Bitcoin was a company, and I understood why. It sounds like a brand. It is not. Bitcoin is a set of rules, written as open software, that lets people send value to each other over the internet without a bank in the middle. A person using the name Satoshi Nakamoto published the idea in 2008 in a paper called Bitcoin: A Peer to Peer Electronic Cash System. The network began in January 2009.

You have probably heard that there will only ever be 21 million bitcoins. That limit is written into the rules, and the people who run the software have agreed to follow it. Nobody can print more on a whim. That is a big part of why folks find it interesting. It is also why the price swings so much, since the supply does not bend to meet demand.

One more thing worth saying plainly. Bitcoin is not a stock, and it is not a bank deposit. No company stands behind it, and no insurance program covers a loss in its price. It is its own kind of thing, and you are wise to treat it that way.

How it works

If you are holding a dollar bill, you know the bank and the government stand behind it. With Bitcoin, thousands of computers around the world keep one shared record of who owns what. This record is called the blockchain. It is a long list of past transactions, grouped into blocks, and every block links to the one before it. Changing an old entry would mean redoing all the work after it, which is why people trust it.

New blocks get added about every ten minutes. Computers called miners compete to add each one, and the winner earns new bitcoin plus the fees people paid. The reward gets cut in half roughly every four years, an event people call the halving. That is how new coins enter the world, a little slower each time.

Now to your ownership. You do not really hold coins. You hold a private key, which is a long secret number that proves a certain balance on the shared record is yours. A wallet is just the tool that stores your keys and helps you send and receive. Lose the key and the coins are gone for good. Nobody can reset it. Let someone else see it and they can take everything.

You can buy through an exchange, which is a company that sells bitcoin for dollars and often keeps the keys for you. That is easy, but you are trusting the company. Or you can keep your own keys in a wallet you control. That is safer from company failure, and harder on you if you slip up. Each path has a cost, and only you can weigh them.

The numbers, and where to find yours

I like to know what a thing costs before I sit down at the table. Exchanges charge a fee when you buy or sell, and the amount varies by company and by how you pay. Sending bitcoin on the network carries its own fee, which rises when many people are sending at once. Read the fee page of any exchange before you open an account, because the fine print is where the cost lives.

On the tax side, the Internal Revenue Service treats virtual currency as property. That means selling it, trading it, or spending it can create a gain or a loss, measured against what you paid. The tax rate on a gain depends on how long you held it and on your income. The one year mark matters here. Holding more than a year generally puts you in the long term bracket, and the long term capital gains rates are the current figure, which the official source publishes each year. Your own bracket and income decide which one applies to you.

You also report it. The yearly Form 1040 asks every filer whether they received, sold, exchanged, or otherwise disposed of any digital asset. You can read the exact wording on the IRS page called Digital Assets, and in the instructions for Form 1040. Keep your own records of the date, the price, and the amount for every purchase and sale. Exchanges may send you forms, but do not count on them to be complete.

A worked example

Let me tell you about a woman named Maria. She is 34 and earns a salary of 52,000 dollars. She has paid off her credit card and has an emergency fund in the bank. One spring she decides to put 1,000 dollars into bitcoin, money she could lose without hardship.

The exchange charges her a fee of 1 percent. She figures the fee this way. 1,000 dollars times 0.01 equals 10 dollars. So 990 dollars actually buys bitcoin. The price that day is 50,000 dollars per coin, and she works out her share. 990 divided by 50,000 equals 0.0198. She now owns 0.0198 bitcoin.

Fourteen months later the price has risen to 70,000 dollars. She decides to sell it all. She multiplies her holding by the price. 0.0198 times 70,000 equals 1,386 dollars. The exchange takes the same 1 percent fee. 1,386 times 0.01 equals 13.86 dollars. She receives 1,372.14 dollars.

Now for the tax. Her cost was the 1,000 dollars she paid out of pocket. That figure counts the 10 dollar fee, because her total outlay is the 990 dollars that bought the coin plus the 10 dollars that paid the fee. Her gain is what she received less what she paid. 1,372.14 minus 1,000 equals 372.14 dollars. She held longer than a year, so this is a long term gain, taxed at the rate for her bracket under the current figure, which the official source publishes each year. She multiplies 372.14 by that rate to see what she owes. Had the price fallen instead, she would have a loss, and the IRS has rules on how losses can offset gains. She keeps her records either way.

Where it goes wrong

I have seen smart, careful people get burned here, and it was never because they were foolish. It was because the thing moves fast and the traps are quiet.

The first trap is the price itself. Bitcoin has dropped by large amounts in short stretches before. If you will need that money soon, it is the wrong place for it.

The second is losing your keys. A written note in a drawer that gets thrown out, a forgotten password, a dead hard drive. Any of these can lock you out for good. Back up your recovery words on paper, and keep a copy in a second safe place.

The third is scams. Real wallet companies never ask for your recovery words, so anyone who does is not one. The same goes for anyone who promises a sure profit or reaches out to you uninvited. The Federal Trade Commission and the Commodity Futures Trading Commission both publish warnings about crypto fraud on their websites, and a few minutes there is time well spent.

The fourth is the tax bill that surprises you. People forget that spending bitcoin on a purchase counts as a sale. Keep track of every move.

And the fifth is the company holding your coins. If an exchange fails, your balance may be caught up in its troubles. Bank deposits have federal insurance, and bitcoin on an exchange does not. Know that going in.

Questions to answer before you leave this page

Could you lose the whole amount you are thinking about and still pay your bills and sleep well? Have you read the fee page of the exchange you plan to use, and do you know what it costs to buy and to sell? Will you hold your own keys or trust a company, and do you understand what each choice asks of you? Where will you write down your recovery words, and who besides you will know where they are? Do you have a simple way to record the date, price, and amount of every purchase and sale? Have you read the IRS page on digital assets so the tax question on Form 1040 does not catch you off guard? And if a stranger promises you easy riches tomorrow, will you remember to hang up?