The Ultimate Guide to Crypto Taxes

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Whether you bought a token for the first time last year, or whether you’re a self-identifying DeFi Degen, this guide has you covered. Either way, the IRS is increasingly focused on crypto investments. The 2021 tax return will have a question on the first page of Form 1040 (that’s your main tax document – see our blog post “2021 Tax Guide for Freelancers” if you need a refresher) asking “At any time during 2021, did you receive, sell, exchange or otherwise dispose of any financial interest in any virtual currency.” You’ll have to answer yes or no. If you get audited, you’re likely to face higher penalties for non-compliance as it will be hard to claim you didn’t know better when the question is posed so blatantly. Furthermore, the IRS is trying to get crypto exchanges to report transaction information for users with certain amounts of trading volume, and is seeing some success in these efforts. That means the IRS could have data on your trades for the year, which will raise red flags if your reporting doesn’t line up with those records.

Crypto Taxation Basics

The IRS treats cryptocurrencies as property. This means if your crypto is held in a taxable account (instead of a retirement account like a 401(k) or IRA) that the profits and losses when you sell are subject to taxes. This is similar to what you would do when selling shares in a company. Let’s go through an example. 

You bought 3 tokens of ABC (a made up cryptocurrency) on Jan 1, 2021 for $100.

  • Short-term capital gains – Six months later, the price goes up to $150 and you sell one of your tokens there. You made a profit of $50, so in your taxes that year you’d have to claim a $50 profit. Since this was held for under 1 year, it’s subject to short-term capital gains tax, which is your ordinary income tax rate. 
  • Long-term capital gains – Let’s say 13 months after the initial purchase, the token is still at $150 and you sell another token. You’ve also made a $50 gain on the sale of this token, but since you held it for over a year it gets long-term capital gains treatment (0%, 15%, or 20% depending on your income).
  • Netting long-term capital gains and losses – Let’s say you sell the third token in the same tax year, but this time the token went down to $20 at the time of the sale. Since you had an $80 loss on the sale of this token (purchase price of $100 – sale price of $20), you can use that to offset the $50 profit on the other token sale that ocurred in the same year. So netting the $50 profit and the $80 loss, you’d have a $30 loss you can claim on your taxes that year. 

You can net long-term capital gains and losses against each other, and the same applies to short-term capital gains and losses. If you have more capital losses than gains, you can deduct $3,000 of losses per year against your ordinary income (26 U.S. Code § 1211). If you have more than $3,000 in net capital losses, the excess losses can be carried forward into future tax years and used to offset capital gains then. You’ll use Form 8949 to track your short-term and long-term capital gains and losses, which you’ll then consolidate on Schedule D. 

Taxable Events

As you saw in the examples above, buying crypto doesn’t create a “taxable event.” However, selling crypto does. If you used crypto to buy a car, the IRS views that as a sale of crypto. This is because the IRS treats crypto as property and not currency. In their eyes, you bought crypto, sold it for USD (the taxable event), and then gave the USD to the car dealership.

This would also be the case for an NFT purchase. If you bought ETH, and then used the ETH to buy an NFT, the IRS views that as: buy ETH, sell ETH, buy NFT. Then, if you eventually sell the NFT that sale would be a taxable event where you’d have to recognize a gain or loss on the NFT. This is the case any time you swap one token for another. So if you’re an active trader, there can be A LOT of taxable transactions that you need to track.

If you have a lot of transactions there is software out there, like Koinly and TokenTax, that connects to your wallet and can help automate these calculations for you (see here for a review of some more popular options). However, some of my DeFi Degen friends have said they don’t always work perfectly (as you’ll see it can get pretty complicated, so it’s understandable…), so it’s important to keep track of it yourself or at least carefully check the tax software’s output if you go that route.

Wash Trading

For most assets, the IRS has rules to prevent wash trading. An example of wash trading would be buying a stock at $100, having it go down to $20 and selling it there to recognize an $80 loss, and then immediately buying it back at $20. In this scenario, you’d still have exposure to the same stock, but at a lower cost basis of $20 now and with an $80 tax loss too. To prevent this, the IRS has the wash sale rule which says you can’t sell an investment at a loss and repurchase a “substantially identical” investment within 30 days. 

Notably, wash trading rules do not apply to cryptocurrency investments at the moment! There have been a few attempts to close this loophole in recent legislation, but at the moment it is currently still usable. In fact, there are some managed crypto investment funds who utilize this exact strategy for investors. These strategies invest in cryptocurrency and automatically sell when the token price dips by a certain amount to harvest tax losses, and then buy it back again shortly thereafter (see a WSJ article on it here). By doing this, you keep exposure to cryptocurrency but generate tax losses each year which can be used to offset gains on other investments. This loophole is likely to get closed at some point in the future, but for now it’s something you can still take advantage of.

Other Crypto Nuances

Airdrops – Crypto protocols will often reward early adopters with what they call an airdrop. For example, in 2021 Ethereum Name Service (ENS) created a token, $ENS, and gave an allocation of the tokens to any wallets that had used their service. Uniswap did something similar. If you claim tokens like this in an airdrop, it is considered income and you have to claim it on your taxes (link). As an example, let’s say you were airdropped 100 tokens of ABC (a made up token) and their fair market value at the time was $20. That’s $2,000 of ABC that you’d have to claim as ordinary income. If you held those 100 tokens of ABC for 18 months, and sold them at $30, then you’d have capital gain of: ($30 sale price – $20 cost basis) x 100 tokens = $1,000 gain which would be taxed as a long-term capital gain. 

Yield Farming – Another potential tax trigger in crypto is yield farming. Yield farming is when you take tokens that you’ve purchased, and you agree to lock them up in exchange for a yield that is typically paid in interest, fees, or new tokens. This is similar to how a Certificate of Deposit, or CD, works at a bank. You agree to give the bank cash for a certain period of time, in exchange for an agreed upon interest rate as an incentive for locking up that cash. The interest that you earn from yield farming is taxable in the US. You’ll need to determine the fair market value of the interest/fees that you receive, and claim it as income on your taxes. You’ll pay an ordinary income tax rate on these earnings, similar to how the interest on a CD is taxed, or the dividends paid by a stock. 

Wrapped Tokens – A wrapped token is when one token’s value is pegged to another coin. Users commonly wrap tokens so they can be used on other protocols. An example of a wrapped token would be if you deposited USDT, a stablecoin, into Aave, a decentralized protocol that lets you earn interest for depositing your stablecoins. When you deposit your USDT you receive aUSDT in return, which entitles you to your share of interest and fees for depositing the USDT. 

Earlier, we said that if you sell a token it creates a taxable event. So would exchanging USDT for aUSDT create a taxable event? Unfortunately, the IRS hasn’t given guidance on this topic yet. In our USDT/aUSDT example, one could reasonably argue that you haven’t actually exchanged a token but simply received a receipt for depositing your USDT. However, the more conservative route would be to treat these as crypto-to-crypto exchanges that result in capital gains and losses. That being said, given the price pegs between USDT/aUSDT, it won’t necessarily mean you owe material taxes on these transfers. 

Liquidity Pools – DEXs are automated market makers that allow people to trade crypto without having a third party or broker act as a middleman to facilitate the trading. For example, if you wanted to trade a stock you’d call Fidelity and put in a buy order. Fidelity would find someone looking to sell, and would act as the middle man facilitating the trade between the buyer and seller. In a DEX like Uniswap, there is a pool of 2 tokens and if you wanted to trade your USDT for ETH, you’d go to that pool and deposit your USDT and receive ETH in return. For this to happen, people have to provide liquidity (the token pairs) to the pool, depositing the tokens that people use for trading. As an incentive for providing liquidity, the liquidity providers typically get a share of the trading fees. 

From a tax perspective, being a liquidity provider has similarities to our Aave example. In that example, someone deposited USDT into the Aave protocol to earn interest and fees and got aUSDT as proof of their deposit. When you’re a liquidity provider, you receive a liquidity provider token that acts as the proof of your stake in the liquidity pool. If you contributed $1,000 to a $10,000 liquidity pool, you’d get a liquidity provider token that represents your 10% ownership in that pool’s assets. 

However, there is a notable difference to being a liquidity provider. Let’s continue with our made up example of a $10,000 USDT and ETH pool. Let’s say there was a bear market and everyone started selling their ETH in exchange for the presumably safer USDT stablecoin. To take this scenario to the extreme, you could end up with everyone selling their ETH and sucking most of the USDT liquidity of the pool. The price of ETH would go down as this happened, but the effect would be that when you went to redeem your 10% stake in the liquidity pool, the ratio of tokens you get back will be very different from when you started. You’ll end up with a lot more of the less valuable ETH, and less of the stable USDT. 

Because of this dynamic, it’s harder to claim that your liquidity provider token represents a receipt for your deposit. Since a liquidity provider’s financial situation rarely looks the same when they exit the pool due to the pool’s changing token ratios, this likely means they have a taxable event. As such, it’s more defensible to take the conservative approach here and say that all of these liquidity provider transactions represent crypto-to-crypto exchanges and are thus taxable events. 

Crypto Loans – If you put up crypto as collateral for a loan, as long as you don’t receive a different token, this is not a taxable event. For example, if you deposit ETH to borrow a stablecoin loan and convert those stablecoins to USD to buy a house, this is not a taxable event. As long as your collateral is not sold or exchanged, there is no tax liability. 

Most protocols that facilitate borrowing require overcollateralization, meaning you deposit more ETH than the stablecoins that you borrow. If the ETH were to trade off, the platform might issue a margin call asking you to deposit more collateral. If you can’t deposit more, they can force a liquidation and sell your ETH collateral. If this happens, you would owe capital gains/loss taxes on the sale of your collateral, even if you don’t receive any of the proceeds. 

If you close out your loan and receive a different coin back, this would also be a taxable event as you traded your ETH for something else. 

One of the newer innovations in DeFi is the Alchemix protocol, which is a self-repaying loan. With Alchemix, you deposit collateral, borrow capital against it, and the protocol invests your collateral to earn yield which repays your loan over time. This creates a taxable event in the form of “Debt Cancellation Income.” If the protocol earned the equivalent of $500 USD of income from investing your collateral and automatically reduced your outstanding loan balance by that amount, you’d have to claim this as income and it would be taxed at your ordinary income tax rate. 

Conclusion

Crypto and DeFi continue to see new innovations every year. While these don’t always fit perfectly into the existing tax and regulatory frameworks, taking the conservative approach and claiming the income should keep you on the IRS’s good side. As crypto and DeFi fans ourselves, we’ll continue to update you on best practices as things continue to evolve! 

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