Wrapped tokens are a terrific option for crypto investors looking to access multiple blockchains. The crypto market has expanded and developed significantly in recent years, and many new blockchains have emerged. By wrapping tokens, investors can choose to place their crypto on whichever blockchain is most appealing to them at the time. However, wrapping tokens adds an additional layer of complexity with regard to crypto accounting and taxes. Let’s take a closer look at wrapped tokens and how they might affect your taxes.
In this article, we will answer the following questions:
- What is Wrapped Crypto?
- What Taxes Apply to Wrapped Crypto?
- When Do I Have To Report My Tax Return for Wrapped Crypto?
- How Are Taxes Determined for Wrapped Crypto?
- What If I Lost Value By Swapping Crypto?
What is wrapped crypto?
Each blockchain has its own native coin. And most blockchains also have tokens created by third parties. What happens if you want to use some of your coins or tokens on a different blockchain than you originally bought them on? Historically, this would be difficult, if not impossible, in most cases. Recent developments, such as wrapped tokens, allow you to shift your crypto assets to other blockchain networks.
A wrapped token is a tokenized version of another cryptocurrency that is pegged to the value of the original cryptocurrency. For example, you may own Bitcoin that you would prefer to use on the Ethereum network. In that instance, you could exchange your Bitcoin (BTC) for Wrapped Bitcoin (wBTC) that could be used on the Ethereum blockchain. The Wrapped Bitcoin (wBTC) would be pegged to the value of Bitcoin (BTC), meaning that the value of Wrapped Bitcoin (wBTC) would increase or decrease in unison with Bitcoin (BTC). In effect, “Wrapped tokens allow non-native assets to be used on any blockchain, build bridges between networks, and implement interoperability in the cryptocurrency space.”
Crypto is wrapped by a custodian. The custodian is not actually a person but rather an entity or instrument like a smart contract, decentralized autonomous organization (DAO), or centralized company. Typically, the custodian holds the original asset and mints a wrapped token of the same value. At that point, the crypto owner can use the wrapped token on the blockchain of their choice. Additionally, the crypto owner can convert their wrapped token back into the original cryptocurrency at any point.
What taxes apply to wrapped crypto?
The I.R.S. has not provided any specific tax guidance regarding wrapped tokens. However, existing law suggests that crypto transactions are subject to taxation whenever a taxable event occurs. In most countries, a taxable event occurs whenever:
- Crypto is sold for fiat currency
- One cryptocurrency is swapped for another
- Crypto is used to purchase goods or services
- Crypto is gifted to another person or entity
There are two schools of thought with regard to whether wrapped tokens are taxable:
The Conservative Approach - When using the conservative approach, wrapping a token is viewed as swapping one cryptocurrency for another. By wrapping the token, a taxable event occurs, and tax liability is created. In this scenario, the crypto owner would report a capital gain or loss depending on how much the asset has increased or decreased in value since its acquisition.
The Aggressive Approach - When using the aggressive approach, wrapping a token is not considered swapping one cryptocurrency for another. Instead, wrapping a token is viewed as continuing to hold the same asset. As a result, a taxable event does not occur, and tax liability is not created. The crypto owner would not report a capital gain or loss.
In our opinion, the aggressive approach looks more like wishful thinking. Past precedent and existing law suggest that wrapping a token is a taxable event and that gains or losses should be reported.
When do I have to report my tax return for wrapped crypto?
When to report wrapped crypto gains or losses depends on whether you prefer the conservative or aggressive approach described above. If employing the conservative approach, you would report wrapped crypto gains or losses at year's end just like you would all of your other crypto trades. If employing the aggressive approach, you would not report gains or losses at all. You may, however, be forced to report back taxes if, in the future, the I.R.S. releases guidance stating that wrapped tokens are taxable.
How are taxes determined for wrapped crypto?
As discussed above, wrapping crypto is most likely a taxable event, and the associated capital gain or loss should be reported. The amount of tax owed is determined by the total gain or loss that results from swapping one cryptocurrency for another. For example, let’s say you purchased one Bitcoin (BTC) for $20,000 and later exchanged it for wrapped Bitcoin (wBTC) once the value of Bitcoin (BTC) had reached $40,000. In that instance, your capital gain would be $20,000. The $20,000 capital gain should be reported at the year’s end, along with all other trading activity.
What if I lost money by swapping crypto?
Whether to report a loss on wrapped crypto depends on your preferred approach and whether you believe a capital loss has occurred. When employing the conservative approach, the process of wrapping crypto is a taxable event. Any loss that results from wrapping crypto should be reported on your taxes as a capital loss. When employing the aggressive approach, however, the act of wrapping crypto is not viewed as a taxable event. As a result, you would not report a capital loss.
When employing the conservative approach, a loss would occur if you bought Bitcoin (BTC) for $20,000 and later exchanged it for wrapped Bitcoin (wBTC) once the value of Bitcoin (BTC) had depreciated to $10,000. In that instance, you would report a capital loss of $10,000. On the other hand, you would not report a capital loss at all if you favor the aggressive approach.
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