Welcome to our second installment of Crypto FAQs. For our second round, we’ll look at some of our most frequently asked questions about what transactions are taxable and determining FMV if there is an illiquid market. This post will answer:
- If I have unclaimed assets in a smart contract, when do I recognize and report that income?
- Is contributing capital to liquidity pools a taxable transaction?
- Is wrapping ETH a taxable transaction?
- How do I determine FMV if there is in illiquid market?
Crypto FAQ: If I have unclaimed assets in a smart contract, when do I recognize and report that income?
Answer: If you currently have unclaimed assets in a smart contract, know that the assets are recognized when they are earned, not when the smart contract is executed. The IRS has guidance known as the ‘Constructive Receipt Doctrine’ that outlines when income should be recognized for tax purposes.
For example, if you are staking Aave, rewards from your staked Aave will be deposited into a smart contract. You must then use gas (gwei) to redeem the funds from the contract. However, you are earning staking rewards over time and have the rights to those rewards and should be reporting that income regardless of whether or not it has been claimed to your wallet yet. If you have additional questions on unclaimed assets located in a smart contract, don’t hesitate to let us know!
Crypto FAQ: Is contributing capital to liquidity pools a taxable transaction?
Answer: Unfortunately, the existing guidance is a little murky in this area. . For some pools, as soon as you deposit funds into this pool, you’ll receive an LP token representative of your share of the pool. If you have a pair of tokens that you contributed, and you received an LP token in return, this represents your deposit and therefore doesn’t mean your tokens were disposed of. However, it could be viewed as a token swap, which would be a taxable event.
There are two taxable transactions when it comes to liquidity pools: the interest earned for providing the liquidity (you can also think of this as earned income). Another taxable transaction is the change in fair market value upon cashing in your LP token(s) for the token pair you contributed; all capital gains and losses will be taxable in this case.
Crypto FAQ: Is wrapping ETH a taxable transaction?
Answer: Wrapping ETH, also referred to as WETH, refers to the token representing Ether that are hosted in the blockchain that has the same price as their underlying assets. In the case that you wrap ETH that you own, you must follow the same guidelines as if you were wrapping Bitcoin. These operations are considered a crypto-to-crypto trade which is a taxable event in the U.S. These transactions are subject to capital gains tax.
Crypto FAQ: How do I determine FMV if there is an illiquid market?
Answer: It sounds complicated to determine the fair market value (FMV) when there is an illiquid market, but the process is the same as if you were determining the FMV for other properties. It is easier to determine some fair-market value prices for some assets over others.
Level 1 assets are the easiest to price as they include the most liquid assets. It’s not common to dispute the prices of a Level 1 asset. While Level 2 assets cannot be valued using the direct market pricing that is used for liquid securities, however, you can determine value based on objective criteria referred to as observable inputs. Examples of observable inputs include quoted trading prices for similar securities in an active market or prices that are quoted for other similar securities in inactive markets.
Finally, Level 3 assets are so rare and complex that there isn’t an available market price for them, including things such as certain derivatives, mortgage-backed securities, distressed debt, and private investments. If you put yourself in the market participant’s shoes, how would you price the asset? To determine their value, you must use mathematical models with subjective assumptions about future events including the risk of default.
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