What Are the Risks, Rewards, and Unknown Tax Implications?
By Brendan Cawley, EA and Ian Coddington, CPA While cryptocurrency has been around since 2008, its popularity has soared over the past two years as people dove into new interests during the pandemic. Whether you used your time in lockdown to learn how to bake banana bread or mine Dogecoins, it’s important to note that the latter may have come with some tax implications.
If you dipped your toes in the virtual currency waters, you may now be wondering — how will my transactions during the year affect my tax return? Our goal here is to give some basic insight into the crypto market, decentralized finance (‘DeFi’), and how the transactions along your cryptocurrency journey can affect your tax return this year and beyond. What Is Cryptocurrency?
The IRS currently views cryptocurrency as a type of virtual currency. Virtual currency, such as Bitcoin, Ether, Roblox and V-Bucks, to name a few examples, is a digital representation of value, rather than a representation of the U.S. dollar or a foreign currency (‘real currency’), that functions as a unit of account, a store of value, and a medium of exchange. Brendan Cawley Ian Coddington Cryptocurrency uses cryptography to secure transactions that are digitally recorded on a distributed ledger, such as a blockchain. The blockchain technology allows participants to confirm transactions without the need for central clearing authority. “The landscape of cryptocurrency and digital assets is evolving daily. The variety of investment options continues to expand, as does the number of investors.” With that in mind, decentralized finance (DeFi) has quickly become the hottest trend in blockchain technology, but it comes with its own uniquely complicated and confusing tax situations. And if learning how to navigate cryptocurrency and DeFi wasn’t complex enough, you have to do so with very little IRS guidance. What Is Decentralized Finance?
When you think of centralized finance, you might think of banks, such as Bank of America or JPMorgan, which traditionally offer savings, lending, and investment options for their customers. Services often come with fees and can result in delays to accessing or withdrawing funds.
By using blockchain technology, users can validate transactions from peer to peer within a matter of seconds. Transactions can take place all around the world across computer networks without the need of a central authority. This is where DeFi comes in, where users can engage in contracts for lending, borrowing, and other financial services at the click of a button. These contracts are created through algorithms, rather than underwritten by a loan officer. Additionally, fees associated with central banks and the delay in completing certain transactions are no longer an issue.
There are several popular DeFi platforms, such as UniSwap, PancakeSwap, Fantom, Aave, and SushiSwap, to name a few. These platforms offer different services to consumers: staking, liquidity pools, yield farming, along with traditional lending and borrowing. Investors who have gotten in at the initial stages have been seeing massive returns on their investments. Services such as yield farming and liquidity pools lock in cryptocurrency assets to facilitate blockchain transactions and pay participants rewards in the form of cryptocurrency. However, the IRS has not determined specific guidance on the treatment of specific transactions within the DeFi space.
Consumers and investors are tempted to participate in the Defi market by varying annual percentage yields (APY) of 3% to 15%, sometimes even more. This is a far cry from the 0.01% APY that you might get in your local bank’s saving account or the 1% APY in a certificate of deposit. The riskiness involved in these transactions, as well as the potential tax implications, might scare off some investors, but with a $114 billion market cap in 2022, there are plenty more who are ready to enter the DeFi space. How Complicated Can It Get?
With the DeFi foundation laid, let’s color the conversation through a real-life example with some surprising complexities. When exploring the world of DeFi, it is unlikely you’ll venture far without hearing about OlympusDAO. What is OlympusDAO? It is a decentralized reserve currency protocol based on the OHM token.
Hopefully, this example will illustrate just how quickly crypto can get complicated. “While some trends at the beginning of the pandemic, such as whipped coffee and banana bread, seemed to dim their lights, the cryptocurrency market is continuing to blaze new trails.” Participants seek returns through staking and bonding strategies. ‘Stakers’ stake their OHM tokens into a pool with other like-minded individuals. Those OHM tokens are then […]
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