How states can prepare for the rise of cryptocurrency
How states can prepare for the rise of cryptocurrency
When global crypto exchange FTX filed for bankruptcy late last year, the critical need for more transparency and accountability in the virtual currency space was highlighted. According to its bankruptcy filing, the exchange could have over $50 billion in liabilities. The Securities and Exchange Commission, the Department of Justice and Bahamian authorities are investigating the case. Unsurprisingly, the FTX implosion has further fueled industry and legislature calls for formal regulations on digital assets.
The core advantage of cryptocurrency is largely its decentralized nature, meaning that it is not controlled by a single person, company or government. Another key feature of cryptocurrency (and any digital asset that operates on a distributed ledger known as a blockchain) is its inherent transparency. In the case of FTX, we now understand that all commercial participants in the crypto ecosystem did not operate with the same transparency that the underlying technology allows. Regulatory certainty began to develop, albeit slowly, Before FTX imploded. Now regulation has started to pick up even more speed.
The road to regulatory clarity began at the federal level last year with the Infrastructure Investment and Jobs Act (IIJA) of 2021, which included a provision requiring all crypto exchanges to report transactions to the IRS. Earlier this year, President Joe Biden also issued an executive order calling for more regulation of the crypto market. But state legislators also have to deal with regulating the use of cryptocurrency. Ideally, regulators at all levels of government should work to encourage more transparency, regulatory clarity, and accountability to help the industry mature — and avoid future FTX-like meltdowns.
Let’s take a look at what states should do in the short and long term to regulate crypto.
Short-term: Offer tax advice
From a tax perspective, the term “cryptocurrency” is somewhat misleading. For federal income tax purposes, cryptocurrency is actually considered a form of property. As such, cryptocurrency is taxed when it is sold – regardless of whether it is traded for US dollars, another cryptocurrency or a service. Crypto is also taxed when mined. Prior to the reporting requirement administered by the IIJA, cryptocurrency capital gains were unlikely to be reported and taxed. From 2023 that will change.
To keep up with the rise of cryptocurrency, states need to clarify their own reporting requirements. Some have already done so: New Jersey, for example, announced plans to comply with IRS guidelines that state taxpayers are responsible for calculating the fair market value of their currency for tax purposes. New York, meanwhile, has said profits and losses from cryptocurrency investments must accrue to the state, just like other digitally-provided assets (i.e., cable, radio, and satellite services).
NFTs or non-fungible tokens may also be taxable. But there are enormous nuances. Not all NFTs represent digital transactions, as some are linked to real-world assets such as works of art or real estate. Minnesota and Washington have already clarified that NFTs are taxable whenever the underlying product is taxable. In the short term, other states should also issue detailed guidance on the classification and taxation of NFTs and cryptocurrency alike.
Long term: Prepare for Web 3.0
While proper regulation of cryptocurrency and NFTs is critical in the short-term, a larger transformation is upon us and regulators should be prepared. Crypto offers a preview of the decentralization that will become the norm for decades to come. Web 3.0, the next iteration of the internet, will be built on top of peer-to-peer networks like blockchain, potentially transforming the digital industry from art and social media to money and finance. States must be ready to face this change as there are numerous state use cases as well. Grants management is just one example. With a digital, decentralized ledger, it will be possible to track money as it travels from the federal government to the state to individuals while verifying the identities of those involved.
This is just one example of a paper-based, manual transaction that can transition to a digital presentation in Web 3.0. Another example is property transfers. The entire billing process for a home (insurance, taxes, ownership) could all be done on the blockchain, which is independently verifiable, transparent, and automated. Instead of a government protecting the house’s title, it will be on the public blockchain ledger, accessible to all. Web 3.0 will also have a snowball effect. As more governments enable digital transactions, the more cryptocurrency adoption they will drive.
The final result
Looking ahead, Web 3.0 will surely be a major transformation for all levels of government. States that do not prepare for this risk being left behind. But the complete transformation to Web 3.0 will not be an overnight process. A more pressing task for state legislatures is to focus on regulation. States need to communicate with residents about tax requirements and thinking about use cases for blockchain in the longer term. By explicitly clarifying tax rules, states can minimize confusion and signal their openness to digital assets and currencies in the future.
The federal government has started paving the way for more regulation of cryptocurrency and NFTs, but it’s still early days. Crypto is undoubtedly in its infancy – and millions of Americans have started experimenting with the rapidly evolving asset class. Despite the recent growing pains, adoption will continue to increase. In fact, crypto is just the tip of the decentralization iceberg. More blockchain adoption is imminent, and states should be ready.
Nathan Jones is SVP and GM of Worldwide Public Sector Sales and Government Affairs at TaxBit.
