The "crypto" in cryptocurrency may sound private, but most cryptocurrencies are very public. After all, public blockchains make transactions known to everyone, and transactions are traceable using wallet addresses. However, a new breed of privacy coins aims to change the game using various innovative techniques.
Let's take a closer look at privacy coins, their complicated legal status, and potential tax implications to remember.
Privacy coins hide wallet addresses and transaction details from prying eyes, but they've come under fire from regulators worldwide.
What Are Privacy Coins?
Privacy coins, also known as private coins or anonymous coins, are similar to conventional cryptocurrencies on the surface. For example, they run on public blockchains that rely on a network of anonymous validators. But under the hood, privacy coins hide transaction details, including the wallet address, wallet balances, and transaction amounts.
On conventional blockchains, validators link the sender address, receiver address, and input and output values on a public blockchain. However, privacy coins use alternative approaches to validate transactions without disclosing addresses or values. As a result, privacy coin users can enjoy complete anonymity from prying eyes.
The largest privacy coins by market cap include:
- Monero – Monero is the leading cryptocurrency focused on private and censorship-resistant transactions and the only cryptocurrency where every user is anonymous by default.
- Zcash – Zcash bills itself as the "HTTPS of blockchains" and the first project to implement zk-SNARKs, a novel form of zero-knowledge cryptography yielding the most robust privacy.
- Decred – Decred is an anonymous digital currency with a hybrid consensus system that supports decentralization, sustainability, and self-ruling capabilities.
- Oasis – Oasis is a leading privacy-enabled and scalable Level 1 blockchain network designed to support Web3, focusing on scalability and high-throughput transactions.
How Do Privacy Coins Work?
Privacy coins use various techniques to hide wallet addresses and transaction details. While Zcash's zero-knowledge proofs are the most well-known technique, new privacy coins are constantly pushing the envelope with new and innovative approaches. As a result, users have many options to protect their privacy.
Some of the most common techniques include:
- Mixers – Mixers take coins from different senders and combine them into a single transaction. After a validator mixes the coins, recipients receive them in newly created wallets. (Dash)
- ZK Proofs – Zero-knowledge proofs to prove that transactions are valid without sharing details. While the math behind these proofs is complex, they are highly-scalable solutions. (Zcash)
- Blockchains – New blockchain designs eliminate the need for addresses altogether and only look at signature data. By matching inputs and outputs, they can validate transactions. (MimbleWimble)
In addition to privacy coins, several projects address the challenge of exposing one's identity when purchasing them. For example, Tornado Cash lets users send ETH and ERC-20 deposits anonymously. Meanwhile, TOR enables users to hide their IP address, making it difficult to trace transactions to a specific location or computer.
Are Privacy Coins Legal?
The U.S. Treasury famously sanctioned Tornado Cash in August 2022, saying it helped launder more than $7 billion since its creation in 2019. In particular, the government noted that it helped launder over $455 million stolen by North Korean hackers. However, crypto advocates argue that sanctioning open source software could mark a dangerous precedent.
Many crypto supporters are suing the Treasury department to try and reverse the order with the sponsorship of Coinbase and other large entities. These parties argue that sanctioning open source software – rather than individuals or entities – marks a dangerous new precedent that could have ripple effects across the tech industry.
While individual tools are easier targets, many governments have taken action against privacy coins. For example, Australia and New Zealand have banned exchanges from offering coins, while Japan banned the coins altogether. Meanwhile, "know your customer" laws have kept many privacy coins off mainstream exchanges in the U.S. and Europe.
Ultimately, privacy coins are likely to remain under scrutiny given their role in high-profile crimes and regulators' inability to track them. While sanctioning or banning projects stands on unsteady legal ground, regulators could make it difficult to transact in these currencies by further enforcing anti-money laundering laws at the exchange level.
What Are the Tax Implications?
Privacy coins are subject to the same tax rules and regulations as conventional cryptocurrencies. In particular, the IRS treats all crypto assets as "property" subject to capital gains taxes. Any income, interest, or rewards may be subject to ordinary income tax at the time of receipt and then capital gains for any appreciation in value over time.
Of course, the inherently untraceable nature of privacy coins may leave some taxpayers to question their need to report income or capital gains. In fact, when President Biden proposed requiring tax reporting on business transactions over $10,000, the value of the Monero privacy coin surged more than 30%, suggesting interest in ways around the new rules.
Privacy coins may be untraceable at the moment, but that doesn’t mean taxpayers should assume anonymity forever. In addition to playing into the government's assumptions that privacy coins are used for illegal purposes (hurting the concept’s public image), the failure to properly report and pay taxes can lead to hefty fines and penalties.
The IRS has no time limit to enforce civil or criminal fraud penalties, meaning taxpayers could be on the hook for unreported crypto income decades later in their lives. As a result, taxpayers should ensure that they keep accurate records and pay their estimated taxes to avoid any troubles – a task that's made easier with the right crypto tax software.
The Bottom Line
Privacy coins effectively hide wallet addresses and transaction details from prying eyes. While they have come under fire from regulators, many privacy coins remain legal for individuals to use. However, it's critical to remember that they have the same tax rules and regulations as conventional cryptocurrencies.
If you trade crypto assets, ZenLedger can help you track your holdings, aggregate transactions across exchanges, and compute your capital gain or loss each year. You can also find opportunities to save money on taxes through tax loss harvesting and other techniques.