How states can prepare for the rise of cryptocurrency

When global crypto exchange FTX filed for bankruptcy late last year, it highlighted the critical need for increased transparency and accountability in the virtual currency space. According to its bankruptcy filing, the exchange could have upwards of $50 billion in liabilities. The Securities and Exchange Commission, Department of Justice and authorities in The Bahamas are all investigating. Unsurprisingly, FTX’s implosion has further fueled industry and lawmakers’ demands for formal regulations of digital assets. 

The core virtue of cryptocurrency is largely its decentralized nature, which means it’s not controlled by any single person, corporation or government. Another key attribute of cryptocurrency (and any digital asset operating 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 were not operating with the same transparency that the underlying tech enables. Regulatory certainty was beginning to evolve, however slowly, before FTX imploded. Now, regulation has begun to gain even more steam. 

The path to regulatory clarity began at the federal level last year with the 2021 Infrastructure Investment and Jobs Act (IIJA), which included a stipulation requiring all crypto exchanges to report transactions to the IRS. Earlier this year, President Joe Biden also issued an executive order that called for increased regulation of the crypto market. But state lawmakers must also grapple with regulating the use of cryptocurrency as well. Ideally, regulators at all levels of government should work to promote greater transparency, regulatory clarity and accountability in order to help the industry mature – and avoid future FTX-like meltdowns.

Let’s take a look at what states should be doing in the near and long term to regulate crypto.

Near term: Offer tax guidance

From a tax perspective, the term “cryptocurrency” is a bit of a misnomer. For federal income tax purposes, cryptocurrency is actually considered a form of property. Thus, cryptocurrency is taxed when it’s sold—whether it’s traded for U.S. dollars, another cryptocurrency or a service. Crypto is also taxed when it’s mined. Before the reporting requirement administered by the IIJA, capital gains on cryptocurrency were unlikely to be reported and taxed. Beginning in 2023, that will change.

To keep up with the rise of cryptocurrency, states must clarify their own reporting requirements. Some have already done so: New Jersey, for one, announced plans to conform to IRS guidelines, which say taxpayers are responsible for calculating the fair market value of their currency for tax purposes. New York, meanwhile, ​​has said that gains and losses from cryptocurrency investments must be sourced to the state just like other digitally delivered assets are (i.e. cable, radio and satellite services).

NFTs, or non-fungible tokens, may also be subject to tax. But there’s tremendous nuance. Not all NFTs represent digital transactions, as some are linked to real-world assets like artwork or real estate. Minnesota and Washington have already clarified that NFTs are taxable whenever the underlying product is. In the near term, other states should also issue detailed guidance regarding the classification and taxability of NFTs and cryptocurrency alike.

Long term: Prepare for Web 3.0

While proper regulation of cryptocurrency and NFTs is crucial in the near term, greater transformation is coming, and regulators should be prepared. Crypto offers a preview of decentralization that will become the norm in the coming decades. Web 3.0, the next iteration of the internet, will be built upon peer-to-peer networks like blockchain—and will potentially transform digital industries from art and social media to money and finance. States must be willing to embrace this change, as there are also numerous government use cases. 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 also verifying the identities of those involved.

That’s just one example of a paper-based, manual transaction that can move to a digital presentation during Web 3.0. Another example involves property transfers. The entire settlement process for a house (insurance, taxes, title) could all be done on the blockchain, which is independently verifiable, transparent and automated. Instead of a government safeguarding the house’s title, it will be on the public blockchain ledger, accessible to all. Web 3.0 will have a snowball effect too. The more governments enable digital transactions, the more cryptocurrency adoption they will drive.

The bottom line

Looking ahead, Web 3.0 is sure to represent a major transformation for all levels of government. States that don’t prepare for it will run the risk of being left behind. But the full transformation to Web 3.0 will not be an overnight process. A more urgent task for state lawmakers is to focus on regulation. States must communicate with residents about tax requirements and think longer term about use cases for blockchain. By explicitly clarifying tax rules, states can minimize confusion and signal their openness to digital assets and currency going forward. 

The federal government has started to pave the way for greater regulation of cryptocurrency and NFTs, but it is still early days. Crypto is undoubtedly past its infancy—and millions of Americans have begun to experiment with the fast-evolving asset class. Despite recent growing pains, adoption will continue to grow. In fact, crypto is just the tip of the decentralization iceberg. Greater blockchain usage is coming, and states should be ready.

Nathan Jones is SVP and GM of Worldwide Public Sector Sales and Government Affairs at TaxBit.