When it comes to generating taxable capital gains with cryptocurrency, many investors believe it only occurs when selling coins or tokens for fiat currency. For example, the US dollar, on centralized exchanges such as Coinbase. However, there is a wider range of crypto transactions that can create capital gains or losses. In this blog post, we will explore three lesser-known methods through which crypto can generate capital gains.
1. Crypto-to-crypto trades:
Crypto-to-crypto trades have become increasingly popular with the rise of decentralized exchanges. By offering a seamless and efficient way to exchange one cryptocurrency for another. What many investors may not realize is that each time they engage in such trades, it generates a taxable transaction and capital gain or loss. For tax purposes, swapping Bitcoin (BTC) for Ethereum (ETH) on a decentralized exchange is viewed by the IRS exactly the same as selling BTC for USD.
2. Spending crypto on goods or services:
The number of businesses providing crypto as an option to pay for goods or services has been steadily growing. If you buy goods or services with crypto that has gained in value, or appreciated, it will generate a capital gain or loss on the purchase. The purchase price of the good or service will be treated as the gross proceeds of the sale. So next time you buy your favorite VPN service with appreciated Bitcoin, be aware you could be paying more than sales tax!
3. Adding (or removing) liquidity to a liquidity pool:
Lastly, a third lesser-known way is adding or removing liquidity to a liquidity pool. Many decentralized exchanges and protocols rely on liquidity provided by users to facilitate trading and function as intended. Liquidity pools are created to ensure there are enough assets available for users to trade against. To add liquidity, you typically need to provide an equal value of two different cryptocurrencies. For example, if you want to add liquidity to an ETH/USDT pool, you would need to contribute an equivalent value of Ethereum (ETH) and Tether (USDT) tokens.
For example, by adding liquidity, you receive special tokens known as liquidity provider (LP) tokens. These tokens represent your share of the pool’s liquidity. The number of LP tokens you receive depends on the proportion of assets you contribute to the pool. These LP tokens are tradable and can be used to redeem your portion of the liquidity pool in the future.
From a tax perspective, upon adding liquidity to the pool, you no longer hold the original coins you contributed and a taxable capital gains event has occurred.
Understanding the various types of crypto transactions, and their tax implications, described in this post allows savvy investors the ability to plan ahead to mitigate capital gains tax on future transactions. Seeking the help of a crypto tax expert is crucial to maximizing your crypto investment goals. While minimizing their tax impact. These three lesser-known ways help shape the world of crypto. Contact us today to find out how we can help you navigate the ever-changing world of crypto.
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