Bitcoin mining: what is it and how does it work?
Bitcoin is a cryptocurrency which has gained great popularity due to its wild price fluctuations and is created through a process known as “mining”. Bitcoin mining is how new bitcoins are put into circulation.
Bitcoin mining is the process of creating new bitcoin by solving extremely complex mathematical problems that verify transactions in the currency. When a bitcoin is successfully mined, the miner receives a predetermined amount of bitcoin.
While the prices of cryptocurrencies and Bitcoin in particular have skyrocketed in recent years, it’s understandable that interest in mining has also increased. But for most people, the outlook for Bitcoin mining is not good due to its complex nature and high costs. Here are the basics of how Bitcoin mining works and some key risks to know.
Bitcoin is one of the most popular types of cryptocurrency, which are digital mediums of exchange that only exist online. Bitcoin operates on a decentralized computer network or distributed ledger that tracks transactions in the cryptocurrency. When computers on the network verify and process transactions, new bitcoins are created or mined.
These networked computers, or miners, process the transaction in exchange for payment in Bitcoin.
Bitcoin is powered by blockchain, which is the technology that powers many cryptocurrencies. A blockchain is a decentralized ledger of all transactions on a network. Groups of approved transactions together form a block and are joined to create a chain. Think of it as one long public record that works almost like a long-lived receipt. Bitcoin mining is the process of adding a block to the chain.
How Bitcoin Mining Works
In order to add a block successfully, Bitcoin miners compete to solve extremely complex mathematical problems that require the use of expensive computers and huge amounts of electricity. The required computer hardware is known as Application Specific Integrated Circuits, or ASICs, and can cost up to $ 10,000. ASICs consume huge amounts of electricity, which has drawn criticism from environmental groups and limited the profitability of miners.
If a miner manages to successfully add a block to the blockchain, they will receive 6.25 bitcoins as a reward. The amount of the reward is halved approximately every four years, or every 210,000 blocks. As of January 2022, bitcoin was trading at around $ 43,000, or 6.25 bitcoins worth almost $ 270,000.
But the price of bitcoin has been very volatile, making it difficult, if not impossible, for miners to know what their payment might be worth each time they receive it.
Is Bitcoin Mining Profitable?
It depends. Even if Bitcoin miners are successful, it is not clear that their efforts will end up paying off due to the high upfront costs of equipment and the ongoing costs of electricity. Electricity from an ASIC can use the same amount of electricity as half a million PlayStation 3 devices, according to a 2019 report from the Congressional Research Service.
One way to share some of the high costs of mining is to join a mining pool. Pools allow miners to share resources and add more capacity, but shared resources mean shared rewards, so the potential payout is less when working through a pool. Bitcoin’s price volatility also makes it difficult to know exactly how much you are working on.
How to start Bitcoin mining?
Here are the basics you will need to start mining Bitcoin:
- Wallet: This is where any Bitcoin you earn from your mining efforts will be stored. A wallet is an encrypted online account that allows you to store, transfer, and accept Bitcoin or other cryptocurrencies. Companies like Coinbase, Trezor, and Exodus all offer wallet options for cryptocurrency.
- Mining software: There are a number of different mining software vendors, many of which are free to download and can run on Windows and Mac computers. Once the software is connected to the necessary hardware, you will be able to mine Bitcoin.
- Computer equipment: The most expensive aspect of Bitcoin mining is hardware. You will need a powerful computer that uses a huge amount of electricity to successfully mine Bitcoin. It is not uncommon for hardware costs to hover around $ 10,000 or more.
Risks of Bitcoin mining
- Price volatility. The price of Bitcoin has fluctuated considerably since its introduction in 2009. In the past year alone, Bitcoin has traded for less than $ 30,000 and almost $ 69,000. This type of volatility makes it difficult for miners to know whether their reward will outweigh the high costs of mining.
- Regulation. Very few governments have adopted cryptocurrencies like Bitcoin, and many are more likely to view them with skepticism as currencies operate outside of government control. There is always the risk that governments will ban Bitcoin or cryptocurrency mining altogether like China did in 2021, citing financial risks and an increase in speculative trading.
Bitcoin mining taxes
It’s important to remember the impact taxes can have on Bitcoin mining. The IRS has sought to crack down on cryptocurrency owners and traders as asset prices have skyrocketed in recent years. Here are the main tax considerations to keep in mind when mining Bitcoin.
- Are you a business? If Bitcoin mining is your business, you may be able to deduct expenses you incur for tax purposes. The income would be the value of the bitcoin you earn. But if mining is a hobby for you, you are unlikely to be able to deduct expenses.
- Bitcoin mined is income. If you are successful in mining bitcoin or other cryptocurrencies, the fair market value of the currencies at the time of receipt will be taxed at the ordinary income rate.
- Capital gains. If you sell bitcoin for a higher price than you received it, it is a capital gain, which would be taxed in the same way as for traditional assets such as stocks or bonds.
Check out Bankrate’s cryptocurrency taxes guide to learn more about basic tax rules for Bitcoin, Ethereum, and more.
At the end of the line
While Bitcoin mining looks attractive, the reality is that it is difficult and expensive to do so profitably. The extreme volatility of Bitcoin’s price adds more uncertainty to the equation.
Keep in mind that Bitcoin itself is a speculative asset with no intrinsic value, which means that it will not produce anything for its owner and is not tied to anything like gold. Your return is based on selling it to someone else for a higher price, and that price may not be high enough for you to make a profit.