The Gray Areas of Crypto Taxation
In the last article, I introduced you to the basics of crypto taxation, including how the IRS, and other taxation agencies around the world, treat digital currencies and other real assets on the blockchain such as property. In particular, I explained how you are supposed to file capital gains and losses for your crypto taxable events. If you have not read
The Easy Part of Crypto Taxation
Now, it would be so much easier to file returns regarding crypto transactions if telling whether a transaction is a taxable event was in
black and white. Unfortunately, that is not the case, especially with more digital asset investment options coming into the picture. There is a lot of gray in between, and that can be very challenging.
We can easily tell that selling bitcoins you’ve been “HODLing” or using to pay for a car is a taxable event. On the other hand, we know without a doubt that sending your crypto coins from one wallet to another you own is not a taxable event. These are basic crypto transactions.
Now, consider the following events.
The Difficult Part of Crypto Taxation
How do you treat utility tokens you received through a token raising (akin to a capital raise) process known as an “airdrop,” which you can either use to access a technology application or sell on an exchange?
How do you calculate what you owe the tax collector when you receive mining or staking rewards (akin to dividends on stocks)? Remember for those with mining operations, you have hardware (depreciation) and energy costs that should be considered.
The examples above are not even the most complex. While it is not expressly clear how you should treat the tokens that come into your possession, you most likely get an inkling on how to go about it when filing your returns. For example, we can easily treat tokens from an airdrop as an income.
However, with the need to minimize your tax obligations, it is possible that how you decide to file your returns regarding this kind of transaction can be interpreted in one way or another by the tax collector. You can’t be sure where you stand.
Now, let’s look at even more complex crypto transactions activities you may have to deal with when filing your returns.
Even More Complex Crypto Taxation
The conventional understanding of lending is that the lender sends the borrower money and waits for the maturity date. The lender might hold collateral to protect their value.
On a decentralized finance (DeFi) platform like Compound Finance, MakerDAO or Aave, just as a normal loan, a DeFi digital asset loan has a maturity date and is also secured through some form of collateral. However, the lender usually receives a token (in place of interest), which they can either hold as a return or sell to other investors on an exchange.
Now, the lender could be considered to have converted their crypto for another crypto when they “stake” their money into the liquidity pool and received another token they can sell elsewhere. That is a taxable event, so in this example, just as dividends are taxable, so are tokens generated from staking activities.
However, it’s not as straight-forward as that because this transaction can also be viewed in another way; in that what the lender deposited in the liquidity pool is still their money and the tokens they receive in exchange is nothing more than a receipt. That means it is not a taxable event.
Meanwhile, on the borrower’s side, it can be argued that depositing collateral and receiving a loan in a different token form is akin to an exchange transaction, so a taxable event. Of course, usually taking a loan is not a taxable event. However, the transaction on a DeFi is unique. Unlike conventional loans, it includes depositing one currency as collateral to receive a loan in another.
Why You Need An Expert Understanding
The status of whether these transactions are taxable events is still up for debate. It hugely depends on who you ask.
We find many of these types of transactions on DeFi applications, which is the newest investment vehicle that many are using to generate value. The processes on these platforms cannot be analogized with anything that happens in the mainstream financial and investment landscape, which would otherwise make it easy to figure out how to proceed.
For example, seeing digital currencies as property means that we should treat them as we do stocks.
These are just but a few of the events on DeFi that are difficult to classify according to what we think the tax collector expects of us. In this category of transactions, and many others emerging, the call between protecting your value (from over taxation) and meeting your legal obligation is very close.
It calls for detailed knowledge of the taxation regime in your jurisdiction and the technical processes involved in the new investment options that blockchain technology and its applications make available to you.
It is for these reasons that you may need to consider engaging the services of tax experts who understand the tax regimes very well, and they need to understand the crypto terrain very well.
You might have to incur a cost, but it is worth it considering what you are avoiding—unwarranted losses and a legal nightmare.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Constantin Kogan is Managing Director at Wave Financial Group and a Partner at BitBull Capital. He has been a cryptocurrency investor since 2012. He has over 10 years of experience in corporate leadership, technology and finance. He contributes to the digital asset space as well as the sharing and value economies.
About Wave Financial
Wave Financial LLC (Wave) is a Los Angeles and London based investment management company that provides institutional digital asset fund products. Led by a team of highly experienced financial services professionals, Wave provides investable funds via their diverse investment strategies applied to digital assets and tokenized real assets. Wave also offers managed accounts for HNWIs and family offices seeking tailored digital asset exposure, bespoke treasury management services, and early-stage venture capital and strategic consultation to the digital asset ecosystem.
Wave is regulated as a California Registered Investment Advisor (CRD#: 305726).
Important Disclosures and Other Information
Nothing in this material should be interpreted as an offer or recommendation to buy, sell or hold any security or other financial product. Past performance is no guarantee of future results. Wave Financial LLC is a registered investment adviser, registered with the state of California (CRD#: 305726). Registration with the state authority does not imply a certain level of skill or training. Additional information including important disclosures about Wave Financial LLC also is available on the SEC’s website at www.adviserinfo.sec.gov. Or, learn more information about Wave Financial at www.wavegp.com.
The ecosystem landscape included in this post is intended to provide generalized guidance; nothing in this analysis is intended as tax advice, investment advice, a recommendation, or an introduction to particular funding or capital resource.