Wrapping Bitcoin and other tokens allows them to be used on different networks. Is the act of wrapping and unwrapping these tokens taxable? Some experts say yes and some say no. We’ll discuss both theories in more detail in this article.
What Are Wrapped Tokens?
We’ve already talked about wrapped tokens in a previous article, but that was specific to OHM forks and other high-yield DAOs. In that context, wrapping the tokens attempts to defer your tax bill on the staking rewards earned until you unwrap or sell your token.
Wrapping tokens in that context is incredibly important, but it’s also very specific to that variety of project – both the mechanism of how you do it and the reason for doing it in the first place.
There are a lot of other wrapped tokens out there that do not earn any interest at all. So why do people wrap them?
Crypto projects run on different networks. Ethereum, Solana, Cardano – they all run on their own networks. This is by design. But one of the current shortfalls is if you have assets on one chain and want to use them another protocol, there isn’t mechanism for that. You can’t use Bitcoin on Ethereum’s network, for instance.
That’s where wrapping comes into play. Wrapped tokens are tokens which are pegged to the value of another cryptocurrency but exist on a different blockchain.
Using the same example of Bitcoin and Ethereum, you can’t spend your BTC to buy something on the Ethereum network. But what you can do is wrap your BTC into wBTC (“Wrapped Bitcoin”). WBTC is an ERC-20 token and exists on the Ethereum network. (Note: this is a very brief explanation since we’re focusing on the tax aspect in this article, but there are numerous guides online if you want to take a deeper dive into wrapped tokens).
Do I Pay Capital Gains When I Wrap and Unwrap My Tokens?
Wrapping tokens can adds tremendous amount of utility, as is showcased by their popularity. For instance, wBTC on its own is currently the 16th largest token in the world by market cap.
But how do they affect your taxes? Because wrapped tokens are not the same as their unwrapped counterparts. They are simply pegged to them. So if you swap BTC for wBTC or ETH for wETH, does that generate a taxable event?
As is the case with most things crypto, the IRS has not issued any specific guidance on wrapped tokens, so this will likely change as we get clarification in the future.
For now, there are two options available on how to treat these transactions on your tax return. We briefly discussed them in our article on liquidity pool taxation:
“There are two basic stances you can take here:
- Conservative: BTC is a separate and distinct asset from the wBTC with different utility. This should be treated as a regular, taxable coin for coin trade
- Aggressive: your wBTC is simply a placeholder for your existing BTC. Wrapping simply adds additional functionality to your existing asset. You can even look at this as just transferring the funds from one bank account to another. You’re moving it from your BTC wallet to your ___ wallet, which requires it be wrapped. But this is not a disposition of your BTC and therefore is not taxable.”
The particulars of the tokens could also come into play. The utility of wBTC is very different than the utility of wETH, for instance. You’re wrapping them for different reasons and are likely using the tokens in dissimilar ways. It is possible that the IRS will look at tokens on a case-by-case basis in determining whether it is appropriate to treat wrapping as a transfer or as a sale.
Work with a CPA Who Loves Crypto
These nuances are part of the reason why working with CPAs, attorneys, and the like who truly understand crypto is so important. Without a more tactile feel and first-hand experience, these subtleties are easily missed.
As always, make sure that you are planning throughout the year and stay tuned for updates. Just like crypto itself, the rules and strategies around crypto taxes change quickly.
Any accounting, business, or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.
