What You Need to Know About Crypto Taxes

Lrn.Fi does not provide tax, legal or accounting advice. This article has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

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Introduction

With tax season recently ending, the average degen is sighing in relief that the nightmare of calculating crypto taxes, whether by hand or through expensive services, is over.  We can resume carelessly executing transactions on the blockchain while figuring our future selves will be the ones responsible for going back and querying through our wallet histories, trying to decipher countless transactions on FTMscan.

This article will help explain some basic tax knowledge and practices that every DeFi participant should be aware of.  Now, there is still a huge cloud of regulatory uncertainty regarding the proper taxation of digital assets.  Fully understanding every nuance and different interpretation of current/future crypto tax law is best left to experts, CPAs and regulators. 

However, it is not difficult for the average joe to be disciplined in properly logging and accounting for their transaction histories, thus reducing the stress and hassle of calculating capital gains and losses.  Even if you still want to hand off the actual math to a tax expert, properly tracking your transactions in a logical and manageable way will drastically reduce the billable hours you will be charged when completing the calculations.

Note: Unfortunately for any non-U.S. readers, most of the information here will be based on U.S. tax law.  Nonetheless, some of these terms and methods for responsible tax accounting will be useful regardless of what legal jurisdiction you are held to.

Calculating Crypto Taxes

One way to get around all this work is to use one of the several automated crypto tax calculators.  These work great for centralized exchanges/services that provide API keys, but not so great for non-custodial wallet transactions executed directly on the blockchain.   Often these services are unreliable and even the paid versions seem to barely work.  

Another option is to pay an accountant to query through your transaction histories for you.  Unfortunately, such accountants usually charge hourly rates in the hundreds.  The time it would take them to decipher your wallet’s transactions can often leave you footing a bill costing tens of thousands of dollars.  This is an unrealistic expense for most of us unless you are A.) a serious whale, or B.) an institution with a team of accountants on hand.

The majority of smaller DeFi players will have to learn to do their due diligence or risk inaccurate/faulty tax reporting.  There’s always a chance you will get away with it, but is it worth the risk of the IRS knocking on your door requesting an audit?  

Know When You’re Being Taxed

The first step to basic tax literacy for all U.S.-based degens is understanding the difference between short-term and long-term capital gains/losses.  Short-term capital gains/losses are triggered by the purchase and sale of any capital asset held for less than a year.  These are generally taxed at ordinary income rates depending on your tax bracket.  Long-term capital gains/losses are triggered by the purchase and sale of any capital asset held for a year or longer.  These are taxed at a lower tax rate than ordinary income.  Therefore investors are often incentivized to hold their assets for over a year to attain these favorable tax rates.

Next, it is important to know what a cost basis is and how to track it.  The cost basis is measured as the amount you paid to purchase your asset.  As a U.S. citizen, the cost basis is denominated in U.S. dollars, even when swapping from one digital asset to another (swapping from ETH to FTM for example).

Finally, you will want to know which actions trigger what is called a taxable event.  These taxable events are moments in our asset transaction history that result in taxes owed to the government.  This is also known as realizing your capital gain/losses.  In U.S. accounting, these realized gains/losses can be calculated using several methods including the FIFO (First In, First Out) method, the LIFO (Last In, First Out) method, or the average-cost method. 

These relate to the order in which you establish your cost basis.  FIFO involves using the earliest purchases/productions of assets (First In) as the beginning of your cost basis calculations, while LIFO involves using your most recently purchased/produced assets (Last In) as the beginning of your cost basis calculations.  The average cost method involves using the average cost of the asset purchased.  This is much less labor-intensive in terms of calculations. 

For more information, there are countless resources online that give more detailed explanations of the calculation of capital gains/losses.  Alternatively, any competent tax accountant should have a full grasp of these calculations as well as when to use each of these cost basis calculating methods.

As mentioned before, there is still a lot of regulatory uncertainty regarding the proper taxation of digital assets.  For this reason, most err on the side of caution, and it is safe to say that most crypto transactions are taxable events.  Let’s go over some of the most common on-chain transactions and what type of taxable events might occur:

Swaps

Swaps encompass all actions related to the purchase or sale of a digital asset, regardless if executed on a centralized exchange or a decentralized exchange.  Every swap must be treated as a taxable event and realized capital gains/losses must be calculated with regard to your cost basis.  Examples of taxable swapping events include:

• Purchasing a digital asset with fiat currency
• Selling a digital asset for fiat currency
• Swapping from one digital asset to another digital asset
• Swapping from one fiat currency to another fiat currency

Transfers

Transferring digital assets from one crypto address to another is one of the few blockchain transactions that one can safely assume is not a taxable event.  Some extremely conservative accountants will count these as taxable, but at that point, you are probably just giving away your money to the government.  Note if you are transferring crypto assets with the intention of making an OTC trade with either an institution or another individual, you will have to consider this transfer as a swap.

Staking

Crypto HODLers often like staking their assets for juicy passive staking rewards.  According to current U.S. Regulations, cashing out on profits from your staking rewards is treated as two separate taxable events:

• The first taxable event occurs whenever you claim your staking rewards.  These rewards will be taxed as short-term capital gains with the value denominated in U.S. dollars at the time of claiming.
• The second taxable event occurs if/when you cash out on your staking rewards by swapping them for fiat currency or another digital asset.  You will use the value of your staking rewards at the time of claiming as your cost basis when calculating capital gains/losses.

Deposits/Withdrawals

Depositing or withdrawing your digital assets from a cryptocurrency protocol’s custody is a very common transaction type on the blockchain.  There is no clear IRS policy on whether these are considered taxable events, so it depends on how conservatively you wish to calculate your taxes. 

 A popular DeFi tactic is to deposit your assets as collateral on a lending protocol, thereby allowing you to borrow other assets that can be used as you please.  In this case, most people do not consider this deposit as a taxable event. This tactic is often used as a way to avoid selling your assets and realizing a gain/loss while still being able to access its capital value.

Liquidity Providing

Another popular activity in DeFi is providing your assets as liquidity to a trading pool in return for yield.  Say you want to provide liquidity for an ETH/BTC trading pool.  This activity involves several taxable events bundled into one:

• Swapping your ETH and BTC for LP tokens is considered a standard swapping taxable event.  Note you will be establishing a cost basis for your LP tokens while also realizing gains/losses from the sale of your ETH and BTC.
• Depositing/withdrawing your LP tokens from the pool can be considered as a taxable or non-taxable event depending on your/your accountant’s interpretation of tax law.  If you are conservative and wish to consider it as a taxable event, then depositing the LP tokens is considered as establishing your cost basis while withdrawing the LP tokens is considered as realizing a capital gain/loss.
• All LP tokens earned as yield/rewards are to be considered as short term capital gains (taxed as normal income).  Much like staking, you must pay taxes on the event of claiming the rewards as well as when you swap the earned LP tokens for other assets.
• Swapping your LP tokens to cash out into either fiat or your original assets (ETH and BTC) is also considered a taxable event.  This is the moment when you realize the gain/loss from when you originally purchased the LP tokens (established as your cost basis).

Rebasing Rewards

Even though the era of OHM-forks seems to be coming to an end, we all still love our ponzis and should understand what sort of taxable events occur.  Conservative accountants will consider every set of rebase rewards as a new short-term capital gain that is to be taxed as normal income.  However, there is a strong argument that rebasing rewards should be considered in the same way that stock splits are, therefore not counting as a taxable event according to the IRS.  As of now, this is again up to you or your accountant’s discretion on how to calculate the taxes owed.

Minting/Purchasing NFT’s

Let’s not forget about all you JPEG traders out there.  Taxes still apply and it is just as important for an NFT trader to track their transactions as it is for a DeFi user.  Let’s say you are minting an NFT on the Fantom blockchain:

• Minting the NFT is considered as establishing the cost basis for that NFT while also realizing a capital gain/loss from the FTM used to mint.  The same applies for purchases from a marketplace like PaintSwap or OpenSea.
• Selling the NFT is considered as realizing your gain/loss based on the cost basis generated from the purchase/mint of the NFT.

Properly Logging Transactions

Understanding what triggers a taxable event is unfortunately only half the battle.  Calculating realized gains/losses by hand will still be tedious and difficult, but proactively logging transactions in an organized fashion will drastically help reduce confusion.  It is ultimately up to you how you wish to format your transaction logs, but it is recommended to utilize a table on a spreadsheet that should look something like this:

The above table depicts the simulated events of a $100 purchase of FTM (going for $0.50 per FTM).  The FTM is purchased on Binance U.S. and then withdrawn to a ledger wallet where it is HODLed for 5 months.  At this point 5 months later, FTM is going for $2.00 per FTM.  As a result, profits are taken as the funds are transferred back to Binance U.S. and then swapped back to USD.   

In this case, the original purchase amount (highlighted in yellow) is treated as the cost basis that is to be subtracted from the final value in USD (highlighted in green).  For this example, the capital gains generated for this set of trades is $398.90 – $100 = $298.90.  Tracking transaction/gas fees may seem like overzealous accounting, but these fees can be deducted from your tax bill so it may be worth it to track these.

Please note that if you are logging transactions for multiple yield farming strategies, it may be better to separate the transactions for each strategy into separate tables.  This will prevent unnecessary untangling of transactions further down the line.  For example, I keep a separate table logged for each crypt that I use within Reaper Farm.

Even with meticulously tracked transaction tables, calculating taxes by hand is still not a fun activity, and most hand this work off to a third party.  However presenting a table, like the one shown in our example, to your accountant will give them access to all the information they need in one, consolidated location.  The information in the table should satisfy any numerical data they need for calculations.  If they do need to dig deeper, they can always view each transaction by searching the transaction ID in a block explorer like etherscan or ftmscan.  

Reaper Farm – Reducing your Taxable Events

By now, you should understand that nearly every transaction completed on-chain is considered a taxable event.  Not only is this a headache to keep track of, but it also creates a high frequency of events that require you to pay some of your sweet gains to the government.  Wouldn’t it, therefore, be better to reduce the frequency of these taxable events? 

Enter Reaper Farm: Fantom’s premier auto-compounder/yield strategizer.  Reaper Farm presents us with various auto-compounding yield strategies in the form of crypts.  These crypts allow us to deposit our funds while the crypt contract executes various transactions on our behalf to farm yield.  Not only is this extremely useful as a “set and forget” farming strategy, but it drastically reduces the number of taxable events triggered by transactions we no longer need to make.

For example, say we want to farm Spooky Swap’s Boo token.  The steps for a common strategy that compounds Boo to generate further yield are:

• Purchase Boo
• Stake Boo on Spooky Swap in return for xBoo
• Stake the xBoo for further token rewards (for this example, let’s assume the APR for LQDR is the highest so we choose to farm that)
• Accrue/claim LQDR rewards.  (Let us assume we claim every 10 days)
• Swap LQDR rewards back to Boo
• Rise and repeat to compound interest gained on your original investment

A table tracking these sets of transactions would look something like this:

Please note all numbers and prices listed are made up for the sake of this example

The table above only extends 20 days past the original investment, meaning we are only accounting for transactions executed for claiming rewards/re-staking twice.  Regardless, you should be able to tell that every reward claim/re-stake cycle creates 2 taxable events.  This will continue every time you decide to compound your rewards back into your original investment until you decide to take profits or exit the position.

Lucky for us, Reaper Farm hosts a single-sided Boo staking crypt.  This crypt takes all the above transactions that you normally complete manually and automates the transactions for you within a script.  It even determines the highest yield token to farm using your xBoo, removing the need for you to make the distinction on your own.  A transaction table depicting the same Boo farming strategy using Reaper Farm’s crypt will look like this:

As you can see, there are no gains/losses realized by taxable events when using the Reaper Farm auto-compounding strategy.  Realized gains/losses will be triggered when you withdraw tokens from the crypt to cash out.  To be safe and conservative, you may want to withdraw and pay taxes on all additional Boo generated from the yield on an annual basis.

In these cases, it seems that using the Single-Sided Boo crypt on Reaper Farm is the obvious choice.  One downside to using Reaper Farm is that it adds an additional layer of smart contract risk.  This means that there is one more layer of code vulnerabilities that could be exploited when compared to manually completing the transactions yourself.  However, the Byte Masons team takes pride in security and is extremely diligent when releasing new crypts for users.  Personally, I believe the risk is negligible, especially when compared to the benefits provided by Reaper Farm.  Trusting the platform to auto-compound for you not only simplifies the tax calculation process but allows you to take a more passive approach to yield farming that requires less active curation.

Closing Thoughts

No one likes talking about paying taxes, much less going through the process of calculating them. It’s an ugly process that only gets uglier in regards to on-chain crypto trading.  Regardless of how painful it may be, it is recommended that you are proactive in tracking your transactions and taxable events.  Good tax record-keeping may seem tedious as it is happening but can save you from hours of back-tracking through your transactions come tax season.

Hopefully this article provided some basic knowledge and best practices that will help protect you from IRS auditing, fines or even jail time.

Sources

Chen, James. “Cost Basis .” Investopedia, Investopedia, 8 Feb. 2022, https://www.investopedia.com/terms/c/costbasis.asp. 

Boyte-White, Claire. “Long-Term vs. Short-Term Capital Gains: What\\\’s the Difference?” Investopedia, Investopedia, 17 Mar. 2022, https://www.investopedia.com/articles/personal-finance/101515/comparing-longterm-vs-shortterm-capital-gain-tax-rates.asp#toc-long-term-vs-short-term-capital-gains-an-overview. 

SoFi. “Crypto Tax Guide 2022: How to Report Crypto on Your Taxes.” SoFi, SoFi, 12 Apr. 2022, https://www.sofi.com/learn/content/crypto-tax-guide/. 

“Frequently Asked Questions on Virtual Currency Transactions.” Internal Revenue Service, IRS.gov, 23 Mar. 2022, https://www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency-transactions.