Passing Down Cryptocurrency Assets: Gifting And Estate Planning Considerations

April 11, 2022

What Is Cryptocurrency?

Cryptocurrency is a digital asset that is created and traded online. Miners (computer operators) establish new units of digital currency and record them on a blockchain, or a string of verified public transaction records. Cryptocurrency records are public, but the identity of the holder is private. Virtual money is traded on exchanges such as Coinbase and Gemini, and a transaction involves the exchange of wallet numbers — no names. There are thousands of types of cryptocurrencies. Common ones include Bitcoin, Ethereum, Litecoin, Chainlink and Dogecoin. Increasingly digital currencies can be used for tangible purchases. For example, Elon Musk announced that Tesla may begin accepting Bitcoin as payment for vehicles. PayPal allows users to buy and hold cryptocurrency in their digital wallets. BNY Mellon announced it will hold, transfer and issue bitcoin and other cryptocurrencies for asset management clients. Many wealth managers have had concerns over the regulatory, legal and stability risks related to managing cryptocurrencies.

Cryptocurrency and Capital Gains Tax

The Internal Revenue Service (IRS) defines Bitcoin and other digital cash as property, not currency. If a client purchases cryptocurrency for personal or investment purposes, any profits from the purchase and sale are subject to capital gains to either short-term or long-term capital gains tax depending on the length of time the assets are held. Usually, crypto investors hold these assets for a short time, but 12 months is the threshold. A taxable event is triggered when cryptocurrency is exchanged for a different brand of cryptocurrency or fiat currency. However, if the individual is in the business of selling or mining virtual assets, ordinary income tax rates apply.

Cryptocurrency losses can also help clients reduce their tax bills. However, under the Tax Cuts and Jobs Act of 2017, cryptocurrency holders cannot use like-kind exchanges to defer capital gains. Individuals should also avoid putting all their assets in cryptocurrency due to the risk and need to be aware of falling victim to crypto-related scams.

What are Nonfungible Tokens?

Nonfungible tokens (NFTs) are digital assets that are unique and cannot be divided, like a work of art or a video. They are traded on various marketplaces like OpenSea. In 2021, sales totaled $23 billion and they can include any of the following:

  • Digital art (with a recent top price of $69 million)
  • Sports collectibles (including animated NBA basketball cards)
  • Gaming collectibles and characters
  • Music
  • Video clips
  • Social media posts
  • Digital real estate

Digital real estate evolved from someone dividing every location on Earth into digital hexagons; so, an individual investor can become the owner of the Empire State Building or the Eiffel Tower. The value of these assets seems questionable; however, investors hope NFTs, like cryptocurrency, will eventually grow in value like rare coins or baseball cards. Twitter founder Jack Dorsey sold an NFT of his first tweet for $2.9 million dollars, making the eventual value of an NFT impossible to predict.

NFTs are also attractive because they connect individual investors to a community. If you own a CryptoPunk, for instance, you are in a common community with Serena Williams, Jay-Z and Logan Paul. While you may not want to spend $172,000 on a digital kitten or trade your Tesla for a picture of a flower, you never know what could eventually become of a sound investment.

Gifting Considerations

Because the IRS treats cryptocurrency as property, it is important that the basis of cryptocurrency be properly documented. Supporting documentation needs to be provided to the donee and also the fair market value of the cryptocurrency on the transfer date. The donor also needs to document the fair market value if a gift tax return is necessary. It is best to obtain an appraisal of the fair market value, but if an appraisal is not obtained, the fair market value should be ascertained and documented by researching the publicly traded prices for the cryptocurrency on the transfer date.

Because cryptocurrency is not formally titled, the donor needs to execute a gift memorandum contemporaneously with the gift for the records of both the donor and the donee. If possible, it is best to have the donee also execute the memorandum or a receipt for the donor’s records. The memorandum should detail all the relevant information including a description of the gift, the type and amount of the cryptocurrency, the date of the transaction, the fair market value of the gift on the transfer date, the donor’s basis in the gift and a statement that the donor has transferred ownership. If the gift is a charitable donation, then the memorandum should include language stating that the gift meets charitable deduction requirements.

It is very difficult to determine the fair market value of cryptocurrency. If the cryptocurrency listed on an exchange is valued according to market supply and demand, and then converted into US dollars at the exchange rate, the cryptocurrency seems easy to value. However, the IRS added a phrase “in a reasonable manner that is consistently applied” to the end of their fair market value calculation answer. This differs from stock on the Nasdaq because the same cryptocurrency can have different values on different exchanges, so valuation may require an appraisal in some situations.

Cryptocurrency Risk

Cryptocurrency has no centralized organization. There is no institution in charge of managing, maintaining or administering it. Transactions are recorded in blocks which are chained together from the previous cryptocurrency transaction — blockchains. A blockchain is an encrypted ledger which is accessible to all the other cryptocurrency owners. It is updated when new transactions occur and is accurate and balanced. It is secure and anonymous and extremely difficult to hack.

Although growing in popularity, investing in cryptocurrency can cause estate planning nightmares. First, cryptocurrency investments are extremely volatile. If an investor’s net worth is over or near the federal estate tax exemption, the cryptocurrency investments must be closely monitored. One suggestion is to donate highly appreciated cryptocurrency directly to a charity. The charity will receive full value of the cryptocurrency and the client will receive a charitable income tax deduction for the fair market value. The charity will not be subject to any capital gains tax on the appreciated value. The investor could also donate to a donor advised fund which accepts cryptocurrency to have the same result.

Another issue is the uncertainty of probate avoidance. Because cryptocurrency is property, if it is titled in an individual’s name without a beneficiary or payable on death designation, it will be included in a client’s probate estate. There are currently no real solutions to this problem. An individual can attempt to title cryptocurrency in a trust, but if an individual’s cryptocurrency is held only on a cryptocurrency exchange, they may not be able to title in trust, add a payable on death designation or add a joint with survivorship owner.

Estate planning attorneys should include cryptocurrency in the definition of personal property in wills and trust agreements and include in their assignments of personal property. However, cryptocurrency will be distributed under the tangible personal property provisions and not under residuary provisions. Estate planning attorneys also have to make sure to authorize fiduciaries access to cryptocurrency wallets and any other cryptocurrency accounts in the estate planning documents.

Finally, while cryptocurrency may be considered “tangible” its digital existence can make it difficult to find or discover the asset when an individual passes away. Investors need to make sure their advisors and fiduciaries are knowledgeable of how to gain access to the cryptocurrency assets. The individual should create a list of online accounts, usernames, passwords, etc.

We recommend that investors and advisors adapt to the growth of these assets and plan appropriately for the future. If you have further questions or are in need of clarifications about this article, please contact KJK Partner and Estate, Wealth & Succession Planning attorney Susie Friedman (SLF@kjk.com; 216.736.7272).