Navigating the Trusts & Estates, and Tax Challenges of Crypto Investing

This article is not legal advice and is for informational purposes only. 

It was not long ago that cryptocurrencies were widely considered to be a niche investment. Interest has grown exponentially over the last couple of years, a trend likely to continue given the incoming Trump Administration's interest in continuing a hands-off approach when it comes to regulation of the crypto space. However, along with this increasing interest in cryptocurrencies comes a set of unique legal, tax, and estate planning challenges—particularly in the context of trusts and estates.

For investors who hold cryptocurrencies, or are considering including them in their estate planning, it is crucial to understand the implications of digital asset ownership in the event of death, incapacity, or tax obligations.

Trusts and Estates: A New Frontier

One of the most pressing challenges in estate planning for cryptocurrency holders is how to properly include digital assets in a will or trust. Traditional assets, such as real estate, stocks, and bonds, have long-established methods for transfer upon death. However, cryptocurrency presents a unique set of issues due to its decentralized nature, lack of physical form, and the security measures used to protect holdings.

1. Custody and Access to Digital Assets

Cryptocurrencies are often stored in digital wallets, which require private keys to access. The private key is a critical piece of information that allows the owner to control their cryptocurrency assets. If the private key is lost or inaccessible, the assets are effectively locked away and cannot be recovered, leaving heirs with no means of access.

When it comes to trusts and estates, this raises significant concerns. How can an executor or trustee ensure that they have access to the deceased’s digital assets? Some investors may opt for custodial solutions, where a third party holds their private keys, but this introduces a new layer of complexity and potential risks. In contrast, non-custodial wallets, where the owner controls the private key, pose the risk of the key being misplaced or lost.

A good solution is to deposit cryptocurrency holdings into accounts managed by a third party such as Coinbase or Kraken. Accounts on deposit with these companies can be accessed like bank accounts, and holdings can easily be converted into fiat or traditional currencies. However, be aware that these deposits are not bank accounts and are not insured or guaranteed by the "full faith and credit" of the United States. 

2. Integration into Estate Plans

For cryptocurrencies to be effectively passed on to heirs, they must be included in estate planning documents like a will or a trust. A clear plan for how the digital assets will be accessed, managed, and distributed should be created. Many estate planners recommend creating a "crypto estate plan," which documents the specific steps for accessing cryptocurrency holdings, including:

• Storing the private key securely but in a location that can be accessed by the executor or trustee.

• Creating a "keyholder" system, where trusted individuals are aware of how to access the assets in the event of death or incapacity.

• Including detailed instructions in the will or trust about how to transfer ownership of the digital assets.

Failing to plan for cryptocurrencies in the estate planning process could lead to complications for heirs who may be unfamiliar with the technology or who lack the ability to access the digital wallets.

Tax Challenges of Cryptocurrency Investments

The tax treatment of cryptocurrencies is another significant area of concern for investors, especially in the context of trusts and estates.

1. Capital Gains Tax and Reporting

Cryptocurrency is classified as property by the IRS, meaning that any sale or exchange of crypto assets is subject to capital gains tax. This can present difficulties when settling an estate, as the value of the cryptocurrency must be carefully tracked at the time of death to determine its basis. If the cryptocurrency has appreciated in value, heirs may be responsible for paying capital gains tax when they eventually sell the assets.

Additionally, cryptocurrency investors are required to report their transactions to the IRS, which can be particularly challenging for those who have multiple wallets, frequent trades, or use decentralized exchanges (DEXs). Executors of an estate must be able to accurately track transactions, compute capital gains, and ensure that proper tax filings are made.

2. Estate Tax Implications

For large estates that include significant cryptocurrency holdings, estate tax considerations come into play. The IRS includes cryptocurrencies in the estate’s total value, meaning that if the combined value of an estate exceeds the exemption threshold (currently set at $6,940,000 for individuals in 2024), estate taxes may be due. Proper valuation of cryptocurrency holdings at the time of death is crucial to ensure the estate pays the correct amount of tax and avoids costly penalties for underreporting.

Furthermore, the fluctuating value of cryptocurrencies can complicate the process. An estate’s crypto holdings may have appreciated dramatically since the time of death, potentially causing the estate to exceed the tax threshold. Conversely, if the cryptocurrency value drops significantly, this could impact the estate’s tax liability.

3. Gift Tax Considerations

Cryptocurrency gifts also raise tax issues. The IRS treats cryptocurrency as property for tax purposes, meaning that gifting large amounts of cryptocurrency can trigger gift tax obligations. If cryptocurrency is transferred to heirs during the lifetime of the investor, it could lead to gift tax consequences, particularly if the value of the cryptocurrency exceeds the annual gift tax exclusion limit (currently $17,000 per recipient in 2024).

Conclusion

As cryptocurrencies become an increasingly mainstream asset class, their integration into trust and estate planning requires careful attention to legal, tax, and technical details. Investors must be proactive in planning for the transfer of these assets, taking into account the challenges of private key management, estate tax implications, and the volatility of cryptocurrency prices.

Given the complexity and rapidly evolving nature of cryptocurrency regulations, it is essential for cryptocurrency investors to work with legal and tax professionals who specialize in digital assets to ensure their estate plans reflect the unique characteristics of these investments. By addressing these issues upfront, investors can better ensure that their cryptocurrency holdings are passed on smoothly to their heirs, without unnecessary complications.