Getting rekt is bad. Getting tax-rekt adds insult to injury.
Cryptocurrency investing is challenging enough on its own. The degen objective is to avoid suffering losses from hacks and rug pulls in the process of reaping oversized decentralized finance (DeFi) returns. There's no greater thrill than stuffing your bags from the numerous ways you can monetize in crypto such as airdrops, staking rewards and yield farming.
Kirk Phillips is a CPA, entrepreneur and founder of Global Crypto Advisors and Crypto Blocko, a business, accounting and tax resource site. This article is part of CoinDesk’s Tax Week series.
However, the tax impacts of the good, the bad and the ugly events are often overlooked, for three main reasons:
- Modular ”lego” money results in new types of transactions and events in crypto with no legacy comparison so there tends to be a regulatory lag before the guidance catches up. More crypto tax guidance is needed in the U.S. and around the world. For example, the treatment of non-fungible tokens (NFT), airdrops, wrapped tokens, staking, casualty losses, liquidity positions and impermanent loss are still question marks to varying degrees. Tax brain-teasers are not just about whether an event is taxable but, rather, the character and timing of the income coupled with readily identifying fair market value.
- Crypto tax software providers are also playing catch-up, trying to roll out features fast enough to keep pace with all the innovation. Just consider the sheer number of blockchains getting traction multiplied by all the decentralized exchanges (DEX), NFT marketplaces, bridges, layer 2 networks and so on. Crypto is no longer a game of calculating capital gains and losses from a static portfolio. Even though crypto tax software has made huge strides in the past eight years, including enterprise-grade versions, there are plenty of taxpayer use cases from individuals to businesses, with no one-stop solutions. This means degens who are on every chain and every DeFi platform are left with no software options. How are you supposed to manage taxes when you have no tools to do it?
- Finally, taxpayers lead themselves down a false path from the crypto tax "telephone game" where small misconceptions about crypto tax get magnified. In addition, many people fail to understand tax basics and ask the right questions, or choose to deal with it later. Twitter, crypto conferences and news outlets can spread information like wildfires. The recent Internal Revenue Service staking refund offer in the Jarrett case garnered headlines like "huge win" and "staking is now tax-free," as if there will never be a tax. There are multiple definitions and types of staking, and that kind of chatter could lead people to believe all staking is tax free. It’s not.
The combination of a lack of guidance, the crypto tax software lag and misconceptions about crypto taxation explains how degens and noobs alike get tax-rekt. These are the ingredients for a surprise tax liability. The insult to injury is having to sell crypto assets in a bear market to pay the tax bill.
What does getting tax-rekt look like for crypto holders?
Let's start with a nice airdrop example where Bob HODLs and stakes 120,000 AAA coins. He finds a Twitter post announcing an airdrop of BBB coins to AAA token holders. Bob loves airdrops so he claims 80,000 BBB after completing a few tasks including an on-chain voting proposal. Bob exercised dominion and control of BBB when its value was $1.25 so he has ordinary income of $100,000. The BBB project is offering 110% staking rewards for the first year with reduced percentages thereafter. Of course, Bob jumps on those delicious returns and stakes his entire 80,000 BBB to fatten his bags.
This piece is part of CoinDesk’s Tax Week
For simplicity’s sake, let’s assume Bob is in the 37% federal tax bracket and a state with 3% tax for a 40% total tax. His potential liability from the airdrop is $40,000, but he did not set aside a tax reserve because he has dollar signs in his eyes and wasn't thinking about it. The BBB token price trended up for the next five months until the market fell into a heavy bear slide over the next two weeks.
Meanwhile, the BBB token price got smashed, dropping 65% when some token holders got their unvested tokens and took profits. Bob's $100,000 airdrop is now worth $35,000 and he owes tax of $40,000.
He finally consulted with a certified public accountant (CPA), realized he's getting tax-rekt and decided to cut his losses, unstake and sell. Bob freaks out when he goes to unstake on Dec. 9, 2021, and discovers a 30-day unbonding period. (What, did you think this would be as easy as withdrawing cash from an ATM?)
By the time Jan. 8, 2022, rolls around and Bob's stash gets unlocked his BBB is now worth $22,000 or $0.22 per token. He painfully sells the BBB for $22,000 right away and takes a tax loss of $78,000 ($22,000 proceeds minus the original basis of $100,000 from the airdrop). It's possible the tax loss could have helped offset the $100,000 of airdrop income, but the big tax loss took place in 2022 and it can't be used for his 2021 return.
So Bob has to sell another of his precious cryptos to come up with the $18,000 shortfall ($40,000 estimated tax liability minus $22,000 in proceeds) This cascades into another crypto tax conundrum continuing the downward spiral as Bob continues to get tax-rekt.
Thus far only the original airdrop has been considered so it ain't over yet. Remember, Bob was staking, claiming and restaking BBB rewards at 110% for six months (five months plus the 30-day unbonding period). Bob's uncompounded rewards would have been 44,000 BBB but based on his compounding frequency he actually claimed 72,000 BBB. While BBB was trending up for five months the average price was $2.80, resulting in another round of ordinary income of $210,600 (yikes). The actual calculation for total ordinary income from taking rewards would be the sum of each token claim times the fair market value at the time of the claim. Bob's 72,000 BBB staking rewards are now worth $15,840 using the same $0.22 token price above. He sells this tranche of BBB as part of the same transaction and timing as above, resulting in another huge tax loss of $194,760 ending up in 2022 rather than being available to offset income from 2021.
Read More: US Crypto Tax Guide 2022
This is the definition of rubbing salt in a wound: getting more tax-rekt from the staking part of the scenario that the original airdrop and selling crypto incurring even more gains to pay for more tax.
How not to be like Bob
The most prudent approach to avoid Bob's situation is to use the highest marginal rate for federal and state taxes for individuals, including individuals with pass-through entity income.
This estimate would be 40% to 50% (and for C corporations, 21% plus the state tax rate).
Suppose Alice got the same BBB airdrop as Bob. To avoid his fate, she would have sold 50% of her airdrop for a stablecoin pegged to the U.S. dollar at the time of receipt. For each subsequent staking rewards claim, she would do the same thing and sell 50% for a USD stablecoin, then compound and restake the 60% of BBB. Alice hedges her tax liability to avoid getting tax-rekt and confines her risk to getting rekt on the remaining portion of BBB she keeps in play. She will suffer injury if BBB goes down the toilet but not the insult because she reserved assets for taxes.
This example is the most cautious approach. However, depending on your risk appetite, there is a range of strategies between Alice’s ultraconservative one and the devil-may-care approach that caused Bob’s troubles.
Stablecoins can be redeployed into lucrative liquidity provider (LP) pairs, thus maximizing crypto asset returns while simultaneously hedging tax liability. For example, a DEX may offer a BBB/USDC LP pair for 92% returns. The strategy can be as simple as claiming BBB, selling 50% for USDC then re-staking both assets in a BBB/USDC pair for those nice returns. Since most LP pools are 50/50 pools, the 50% BBB and 50% USDC for the tax hedge is a perfect match.
- Keep up with crypto tax guidance and developments, because you have to consider a tax position even without guidance.
- Track your crypto using crypto tax software and document in parallel to capture those use cases without a tooling solution.
- Don't get sucked in the crypto "telephone game" chatter as the basis for your own tax treatment.
- Use all the tools and tricks in your DeFi toolbox to your advantage and map out a better tax strategy based on your experience in order to stuff your bags and avoid getting tax-rekt.