What Are the Legal Risks to Cryptocurrency Investors?

Along with the explosion of interest in cryptocurrency, there is a growing need for clarity regarding the legal implications of these new currencies and the technologies that drive them. Regulatory agencies, tax authorities, and central banks around the world all are working to understand the nature and meaning of digital currencies. Meanwhile, individual investors can make a great deal of money, but they also assume certain legal risks when they buy and sell cryptocurrencies.

Much of the murkiness surrounding cryptocurrency's legal standing is due to its newness relative to more traditional currency and payment systems, but regulations are slowly becoming more inclusive.

Cryptocurrencies and Taxes

One of the most critical legal considerations for a cryptocurrency investor has to do with the way that government tax authorities view cryptocurrency holdings.

The IRS and Cryptocurrency

In the U.S., the IRS has defined cryptocurrencies as property rather than currencies. This means that individual investors are subject to capital gains tax laws when it comes to reporting cryptocurrency profits and expenses on their annual tax returns, regardless of where they purchased digital coins.

Note that the above is true for investors who buy and sell cryptocurrencies. If you are an employee and are paid in cryptocurrency or receive it as payment for your services, it is taxable as income. The amount is based on the market value of the cryptocurrency at the time it was paid.

IRS Form 8938, Statement of Specified Foreign Financial Assets is required for taxpayers with substantial assets in foreign accounts ($50,000 or more). However, as of November 2024, the IRS has not included cryptocurrency in its definition of specified foreign financial assets. This requirement should be closely watched for in the future, as it's possible the agency will decide to include it.

The US Treasury and Cryptocurrency

Generally, if you hold assets in a reportable foreign financial account that total more than $10,000, you must file FinCEN Form 114, the Foreign Bank Asset Report. However, guidance from FinCEN remains unclear as to whether cryptocurrency is a reportable asset.

A 2020 notice from FinCEN stated that virtual assets held in a reportable account with other reportable assets were required to be reported. It also stated that the Treasury was working on a rule to require virtual assets in foreign accounts reporting, but this notice and proposal were withdrawn in April 2024 for further analysis by FinCEN.

This means FinCEN is still determining how to address international cryptocurrency holdings reporting. Further, it means that investors with cryptocurrency held in custodial accounts outside of the country must proactively discuss their tax situation with a tax attorney familiar with cryptocurrency foreign holdings.

Cryptocurrency's Decentralized Status

One of the great appeals of many digital currencies is also a potential risk factor for the individual investor. Cryptocurrencies, by definition, are decentralized, meaning that they have no physical presence and are not backed by a central authority.

While governments around the world have stepped in to assert their regulatory power in various ways, BTC and other digital currencies like it remain unattached to any jurisdiction or institution.

On one hand, this frees investors from being beholden to those institutions. On the other hand, this status could result in legal complications.

When There's No Central Authority

The value of digital currencies is dependent entirely upon the value that other owners and investors ascribe to them; this is true across all currencies, digital or fiat. Without a central authority backing the value of a digital currency, investors may be left without legal recourse should complications with transactions or ownership arise.

Another potential risk associated with cryptocurrencies as a result of their decentralized status has to do with the particulars of transactions. In many transactions, currency with a physical presence changes hands.

In the case of electronic transactions, a trusted financial institution is involved in creating and settling deposits and debt claims. Cryptocurrencies can be transferred using intermediaries which offer some protections, but peer-to-peer transactions remove any protections.

Because of this fundamental difference, legal confusion between parties in various types of digital currency transactions is a real possibility. Once again, because of the decentralized state of these currencies, the path of legal recourse in these situations can be difficult to assess.

Fraud and Theft

Cryptocurrencies provide criminal organizations and individuals another means of committing fraud and a host of other financial crimes. Investors may find themselves in the unfortunate position of being a victim of financial crime, and may not have the same legal options as traditional fraud victims.

This issue also relates to the decentralized status of digital currencies. When a cryptocurrency exchange is hacked and customers' holdings are stolen, for instance, standard practices for discovering where the missing funds went have been developed. Addresses can be identified, and messages sent to them, but unless the thieves inadvertently identify themselves or send the funds back, there is usually no way to recover them.

Most regulated exchanges carry crime insurance that covers investors' holdings if their internal systems are hacked, but if a theft occurs because a user's exchange account or personal wallet was hacked, there is often no recourse.

Digital currency investors thus take on a certain amount of risk by purchasing and holding cryptocurrency assets.

The Bottom Line

Developers and startups related to digital currency have focused a great deal of attention on creating secure means of holding digital coins and tokens and mitigating the risks users and investors inherit. Cryptocurrency exchanges are always working to improve their security measures, but investors in some areas have not been able to mitigate all of the legal risks associated with owning cryptocurrencies.

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