When it comes to estate planning, very little has been mentioned about bitcoin. While bitcoin is subject to wills and revocable living trusts like any other asset, there are some special considerations.
Most seasoned holders of bitcoin are aware of IRS Notice 2014-21. For those unaware, the notice holds that for US tax purposes, bitcoin is to be treated as property rather than currency. The notice is wrongheaded, foolish and probably was issued with intent to slow down bitcoin adoption. Nonetheless, we’re stuck with it until bitcoin adoption increases to the point where the IRS recognizes it as a currency.
Much ink has been spilled about the more obvious consequences of bitcoin’s classification as property, namely:
- Whenever bitcoin is spent on goods or services, the spender must recognize taxable income or loss on the difference between tax basis (usually the price at which he acquired the bitcoin) and the fair market value of the bitcoin at the time spent.
- Bitcoin miners must recognize ordinary income equal to the fair market value of the bitcoin mined at the time of mining.
- If your employer pays you in bitcoin, such payments must be reported on your W2 and are subject to tax withholding in US dollars.
Beyond these more obvious consequences, however, there are some hidden estate planning traps when it comes to the death or incapacity of a bitcoin account holder. To avoid these problems, here are five steps you need to take now in your estate plan.
1. Get your step-up in your estate plan, and watch your step-down
Because bitcoin is property, when a bitcoin holder dies, the beneficiaries of his will or living trust receive his bitcoin with tax basis at the fair market value on the date of death. For example, assume I inherit 100 BTC from my mother, and on her date of death 1 BTC is worth $250. If 1 BTC is worth $260 at the time I later spend 1 BTC in that scenario, I have a taxable gain of $10 on my bitcoin use. The fact that my mother only paid $150 for that bitcoin when she acquired it isn’t relevant for tax purposes once she has passed.
This is a double-edged sword. For highly appreciated bitcoin, this may be a boon. For bitcoin that has depreciated since purchase, this could be a disaster. For example, in the hypothetical above, if my mother had paid $1,000 for 1 BTC, upon spending I would still have a taxable gain of $10, because the only relevant factor is the fair market value on my mother’s date of death.
If you’re older and have appreciated bitcoin, it makes sense to hold onto it as long as you can so that your heirs can take advantage of the step-up. The step up may be able to eliminate all taxation of the gains on your investment.
On the other hand, if you’re older and have depreciated bitcoin, it may make sense to spend it as quickly as possible and preserve your cash. Upon spending, you’ll recognize taxable losses (which may possibly result in a reduced overall tax bill) and you’ll avoid your tax basis being stepped down at death.
2. Make sure your executor or trustee is aware that your bitcoin exists
If you tend to be private, your loved ones may never even know that you have bitcoin. Due to the anonymous nature of bitcoin, if they aren’t aware of it, your bitcoin will die with you. To avoid this result, set up some method of informing your loved ones that you’re a bitcoin holder. If you’re uncomfortable telling them now, check out a service like Deathswitch which will automatically inform them when you’re gone.
3. Make sure your executor or trustee can get your private key
Bitcoin isn’t like a bank account where your loved ones can simply contact the institution once your will has been probated. Without your private key (or in the case of a hosted walled like Coinbase or Circle, your username/password), your executor will be totally powerless to distribute your bitcoin under the terms of your will.
Since most of us don’t like passing our private keys or login info around, consider using the Deathswitch option. You can always encrypt your bitcoin key or Coinbase/Circle login before uploading to Deathswitch. [Just make sure your recipient is given the decryption key for the message ahead of time!]
4. Make sure power of attorney allows your agent to access your bitcoin
Many of us have a power of attorney document in place. This allows someone to handle our legal and financial affairs if we’re alive, but incapacitated. This person may need to handle your bitcoin. To make sure this happens, make sure that your power of attorney document explicitly allows your agent to access either your bitcoin specifically, or your digital assets broadly. And like your executor, your agent under your power of attorney is going to need access to your private key or login info.
5. Beware of the Prudent Investor Act
Most states have enacted some version of the Prudent Investor Act, which requires that executors and trustees diversify investments. If someone is to die holding a large amount of bitcoin, there is a argument that under the Act the bitcoin wuld be considered an “investment” rather than cash, and a volatile one at that. Such a classification may mean that an executor or trustee may be required under the Act to sell bitcoin and diversify into traditional securities. This may not be what the deceased party intended.
The good news is that the Prudent Investor Act generally allows itself to be explicitly overridden. Should you desire your executor or trustee to have the power to hold your bitcoin long-term, consider a specific provision in your will or trust absolving him from any liability for failure to diversify bitcoin.
Like everything else involving estate planning, we never know when something when incapacity will come. By then, it’s too late to plan. If you’re a bitcoin holder, that means there is no excuse to procrastinate on these five points.
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