Top 3 Crypto Tax Mistakes
Three mistakes I've made so far from earning and trading crypto:
🚜 Not selling yield farming rewards
🤑 Using Bitcoin as an intermediate token for trades
👝 Not using a separate wallet for trading and for income
Let's dig in on each of them...
Caveat: These mistakes depend on local tax rules.
🚜 Not selling yield-farming rewards
Rewards earned for yield farming are typically considered income and often taxed at the same rate as a salary would be.
If one holds the rewards rather than selling them, one runs into the risk that the rewards fall in price and one ends up paying more taxes than what the rewards are later worth!
Specific example:
Consider earning 1 FARM token as a reward when the value of 1 FARM token is $100.
This $100 is typically taxable income. At a 40% rate of tax, this would be $40 in taxes owed.
Consider now holding that FARM token while the price of 1 FARM falls to $20.
RESULT: The value of rewards received is now only $20, but $40 of taxes are owed. Ouch!
Potential solution:
Sell rewards immediately (unless one has confidence in the price of rewards rising over time).
Technical note:
Yes, if one sells the FARM token for $20, one can offset a loss of $100 - $20 = $80 against any capital gains (assuming one has any gains), so there is some mitigation. At a 20% capital gains tax rate, the mitigation would be 20% x $80 = $16. However, capital gains rates are often lower than income tax rates, so - if token prices drop steeply - it is still possible to end up owing more taxes than the value of rewards held. Further, in a downmarket, one may not have any gains against which to offset losses.
🤑 Using Bitcoin as an intermediate token for trades
When buying certain alt-coins it's common to first trade fiat for Bitcoin and then trade Bitcoin for the altcoin one wants, e.g. Stacks token. [The same is often typical for Ether or USDT as an intermediate token].
If one doesn't already own any Bitcoin, this isn't an issue. The Bitcoin is bought and immediately re-sold. There is minimum gain or loss to consider for tax purposes.
However! If one already owns Bitcoin, doing an intermediate trade through Bitcoin can result in a taxable event whereby one's originally owned Bitcoin is considered to have been sold.
The specifics of this issue depend on tax rules in one's jurisdiction:
In regions with First in First out (FIFO) treatment, there is a taxable event involved in doing an intermediate token trade. This is because gains on any Bitcoin sold are compared to the earliest purchased Bitcoin holdings (not the most recently purchased).
In regions with Last in First out (LIFO) treatment, Bitcoin sales are compared to the most recently purchased Bitcoin holdings, so there is typically little gain or loss recorded.
In regions with Highest in First out (HIFO) treatment, Bitcoin sales are compared to one's most expensive (based on historical unit price) Bitcoin holdings. In this case, depending on one's historical cost basis, there may or may not be a disadvantageous loss/gain to be realised by using Bitcoin in an intermediate transaction.
Potential solution:
Avoid trading via tokens one already owns, like Bitcoin and Ether. If an intermediate trade is required, it's best to trade via a stablecoin. Since the value of stablecoins is typically more stable in one's local currency, gains/losses realised on trades are typically small.
👝 Not using a separate wallet for trading and for income
This isn't a mistake that generates extra taxes, but it wastes time spend calculating taxes.
In short, it's simpler to keep wallets for earning (e.g. revenue from products or services) separate from wallets used for trading or yield farming). Most tax software (including Celo.Tax) allows one to select whether incoming transactions are treated by default as income or rewards or deposits. Keeping trading wallets and income wallets separately helps one to take advantage of this feature.
What Celo.Tax is doing to help?
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