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 investing in them, but they also assume certain legal risks when they buy and sell cryptocurrencies.

Much of the murkiness of the legal standing of cryptocurrency is due to its newness relative to more traditional currency and payment systems.

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. In fact, their views are evolving, and cryptocurrency investors need to keep an eye on their latest pronouncements.

Capital Gains 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 receive cryptocurrency as salary, it is taxable as income. The amount is based on the value in U.S. dollars of the cryptocurrency at the time it was paid.

Cryptocurrency and Foreign Bank Account Regulations

Cryptocurrency trading frequently involves holding cryptocurrency in a foreign account. As of August 2023, federal law does not view a foreign cryptocurrency account as a type of "reportable account." That is, cryptocurrency account holders are not required to file disclosures of their foreign accounts to the Financial Crimes Enforcement Network (FinCEN), an agency of the U.S. Treasury Department.

Commonly called an FBAR, for Foreign Bank Account Report, this is FinCEN Form 114, and it must be filed by holders of substantial overseas accounts.

Cryptocurrency wallets are not included in that requirement but that could change at any time. FinCEN intends to propose amending the filing requirements regarding foreign bank accounts to include cryptocurrency holdings.

Cryptocurrency and the IRS

IRS Form 8938, known as FATCA, is the tax agency's version of FinCEN's FBAR. Taxpayers with substantial assets in foreign accounts are required to file this Statement of Specified Foreign Financial Assets as well as the FBAR.

As of August 2023, the IRS has not definitively ruled on the subject. The question of whether cryptocurrency wallet owners must report their holdings using Form 8938 is unclear. Blogs for lawyers, accountants, and cryptocurrency investors are awash in the debate over whether a wallet is a financial institution, or whether the IRS thinks it is.

Keep in mind, given the severe penalties for failing to file an FBAR, a FATCA, or both, owners of cryptocurrency wallets should file both forms. Infractions are punishable with a $10,000 fine or half the account value, and criminal penalties are possible.

At the very least, consult a tax professional who has some familiarity with cryptocurrency when it comes time to file your taxes.

Cryptocurrency's Decentralized Status

One of the great draws 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 in the lurch 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 most other 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. Neither of these concepts applies to cryptocurrency transactions.

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.

Cryptocurrency Registration and Licensing

A growing number of businesses are taking digital currencies as a form of payment. In 2023, you could spend your Bitcoin at Microsoft's Xbox Store, Home Depot, and Whole Foods.

As in other financial areas, businesses may eventually be required to register and obtain licenses for particular jurisdictions and activities. However, due to digital currencies ' complex and evolving legal status, this area is significantly less clear for businesses operating in the cryptocurrency market.

Companies that only accept cryptocurrencies, for example, may not need to register or obtain licenses at all. On the other hand, they may be required to submit to special considerations depending upon their jurisdiction.

The onus of responsibility falls on business owners and managers to ensure that they follow proper legal procedures for their operations at both the local and state levels.

For example, at the federal level, financial institutions must maintain certain protection activities against money laundering and fraud, the transmission of funds, and more. Considerations like these also apply to businesses dealing with digital currencies.

Fraud and Money Laundering

There is a widespread belief that cryptocurrencies provide criminal organizations with a new means of committing fraud, money laundering, and a host of other financial crimes. This may not directly impact most cryptocurrency investors who do not intend to use this new technology to commit such crimes. However, investors who find themselves in the unfortunate position of being a victim of financial crime do not likely have the same legal options as traditional victims of fraud.

This issue also relates to the decentralized status of digital currencies. When a cryptocurrency exchange is hacked and customers' holdings are stolen, for instance, there is frequently no standard practice for recovering the missing funds.

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

The Digital Security Issue

This is why developers and startups related to digital currency have focused a great deal of attention on creating secure means of holding digital coins and tokens. Still, while new types of wallets are being released all the time, and while cryptocurrency exchanges are always improving their security measures, investors have so far not been able to fully eliminate the legal risks associated with owning cryptocurrencies, and it's likely that they never will.

Investing in cryptocurrencies and other Initial Coin Offerings (“ICOs”) is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or other ICOs. Since each individual's situation is unique, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein.