Beyond Bitcoin: Challenges to applying a standardized Digital Asset Classification System

James McDonald on April 27, 2022

Author: James McDonald, Product Manager in Data and Analytics

In part two of the Beyond Bitcoin series, we discussed how the application of a standardized sector methodology can benefit investors through increased transparency and ultimately help in the adoption of digital assets. We covered how digital asset sectors assist with portfolio management, applying investment guidelines, indexing, and benchmark construction, as well as providing the opportunity for the creation of new investment products.

With such clear benefits, why haven’t we seen a standardized sector classification by the industry that has grown for over 10 years since the launch of Bitcoin??

In part three of the Beyond Bitcoin series, we dive into the challenges of adoption as well as mitigating factors that firms should consider when adopting a digital assets classification system.

Challenges of Sectoring Digital Assets

The broad adoption of a digital assets sector classification system has the capability to provide When attempting to classify digital assets into various levels of a sector taxonomy, there are many challenges that Investors should be aware of:

  • Speed of the Digital Assets Market: The crypto asset ecosystem has evolved rapidly with the rapid creation of new ecosystems, projects, web3 use cases, protocol updates, and the list goes on. It can be difficult for an individual or entity to keep up with one niche area of the market, let alone trying to stay in touch with developments across the entire ecosystem.
    • While one could argue this is a necessary component of a growing ecosystem, staying abreast of these changes can be problematic when attempting to leverage a full-scale sector classification system.
  • Lack of Standardized Quantifiable Criteria for Sectoring Digital Assets: Existing classification systems, such as the Global Industry Classification Standards (GICS), will leverage standardized quantifiable criteria such as revenue or earnings to help classify a public company within the equities market. However, a standardized metric such as revenue that applies to all digital assets doesn’t exist yet, making it challenging to implement a classification system in an impartial way. To date, most providers of classification systems will classify an asset based on the main use case of the underlying asset or project and how that use case fits into the broader ecosystem.
  • Lack of Standardized Terminology through the Digital Asset’s Markets: Most veterans of the digital asset markets would agree that the crypto ecosystem has a jargon and abbreviation problem. Terms like DeFi, CeFi, HODL, WAGMI, IDO, token vs coin, NFTs, Dapps, Layer 1, 2, 3, and now Layer 0 protocols, are just a few examples that could cause a headache for even the most seasoned investors. 

But the underlying problem when defining a sector classification is that different entities may interpret crypto jargon in different ways. For example, the term Decentralized Finance (DeFi) could mean net new financial services utilizing digital assets (such as yield farming or liquid staking), or disrupting legacy financial services in a decentralized way (Borrowing/Lending in a P2P manner), or both. This can pose challenges when examining the categorization of sectors because there may not be one agreed upon definition, and differing definitions across entities for the same terminology create confusion, especially for new investors.

When considered individually, these challenges can be troublesome and if aggregated they can lead to some common mistakes that occur when classifying digital assets. Not having effective mitigation in place for these challenges creates deeper problems when forming a classification hierarchy. Some of these challenges include:

  • Lack of Asset Coverage: Some providers may opt to only choose the most liquid assets or specific types of digital assets, ignoring the broader market picture and potentially missing out on new or emerging types of assets in the space.
  • Inadequate Classification Granularity: The digital assets markets are complex which can cause some classification systems to not go deep enough when trying to classify assets. Granularity in a classification system is critical to ensuring assets are categorized correctly, and by choosing to focus on a specific asset universe or specific segment of the market, existing classification systems may lack the needed depth to provide value to investors.
  • Classification Structure that is too rigid: The speed of disruption and level of innovation within the digital assets market is historical. Some classification providers may only provide one classification for one asset (based on one specific use case), which can be troublesome when assets span multiple different use cases and niches within the crypto ecosystem. If the classification system is too rigid and not able to encompass a primary/secondary structure, investors may miss the bigger picture for a specific asset

Addressing the Challenges

Unfortunately, when examining the above challenges, we lack a single mitigating action to address the complexities of classifying digital assets. The challenges outlined above are the product of rapid growth in a new industry that is changing the way assets are exchanged. 

What can investors, and the broader market, do in the short term to help mitigate the challenges of digital asset classification while they continue to mature?

  • Robust Governance and Oversight Framework from Classification Providers: Digital Assets Market participants should look for a sector classification provider that has an institutional level of governance that is rooted in open and transparent communication.

Due to the nascent nature of the market, sectoring digital assets can be more of an art than a science. Providers in the space can help mitigate the uncertainty by establishing a framework for oversight and governance that seeks to standardize the digital asset sectoring process through policies such as:

  • Sector additions and deletions are subject to an oversight board. Formal policies and procedures can address the breadth and depth of the market considered in the sector taxonomy,
  • Implementing guidelines for communicating classification updates with consumers when there are changes in the sector taxonomy or changes to the sectoring of specific assets,
  • Institutional quality data checks that are reviewed on a set frequency to ensure that the classification structure is maturing along with the evolution of crypto assets,
  • Robust methodology that outlines the process for assigning a sector to an asset in order to promote transparency in absence of standardized reporting metrics within these markets.

As the Digital Assets asset class grows and matures, the demand for new products and tailored exposures from market participants continues to increase. Applying a standardized sector classification system can be burdensome to new market participants or service providers who operate in the digital assets ecosystem. However, trusted providers are already working to address these short-term growing pains and as the market continues to mature, standardization will follow.

These challenges are not insurmountable and the net impact of applying a sector classification system will undoubtedly make digital assets more accessible, inclusive, and understandable for new investors.

About Lukka

Lukka is a firm that helps solve some of the greatest financial challenges in crypto and has the intellectual resources, along with the data and processing capabilities, to test hypothetical scenarios like the one here. For more information on how Lukka puts data to work across multiple finance sectors, traditional and decentralized, supporting industries from insurance to Formula E, go to our website at Lukka.tech

DISCLAIMER

THE INFORMATION CONTAINED IN THIS BULLETIN PROVIDES ONLY A GENERAL OVERVIEW OF CURRENT ISSUES RELATED TO DEBT FINANCING IN CRYPTOCURRENCY MARKETS AND SHALL IN NO EVENT BE CONSTRUED AS THE RENDERING BY LUKKA OF PROFESSIONAL ADVICE OR SERVICES. AS SUCH, THE INFORMATION PROVIDED IN THIS BULLETIN SHOULD NOT BE USED BY YOU AS A SUBSTITUTE FOR CONSULTATION WITH PROFESSIONAL ADVISORS. BEFORE MAKING ANY DECISION OR TAKING ANY ACTION REGARDING YOUR DIGITAL CURRENCIES OR THE DEBT TREATMENT THEREOF, YOU SHOULD ALWAYS CONSULT WITH AN APPROPRIATE FINANCIAL, LICENSED TAX, ACCOUNTING, OR OTHER PROFESSIONAL. TO THE FULLEST EXTENT PERMITTED BY LAW, IN NO EVENT WILL LUKKA(INCLUDING ITS RELATED ENTITIES, OWNERS, AGENTS, DIRECTORS, OFFICERS, ADVISORS, OR EMPLOYEES) BE LIABLE TO ANY READER OF THIS BULLETIN OR ANYONE ELSE FOR ANY DIRECT, INDIRECT, OR CONSEQUENTIAL LOSS OR LOSS OF PROFIT ARISING FROM THE USE OF THIS BULLETIN, ITS CONTENTS, ITS OMISSIONS, RELIANCE ON THE INFORMATION CONTAINED WITHIN IT, OR ON OPINIONS COMMUNICATED IN RELATION THERETO OR OTHERWISE ARISING IN CONNECTION THEREWITH.

Crypto Actions, Part 1: Blockchain Migration and Hard Forks

Suzanne Morsfield on March 22, 2022

Author: Adam Katt and Olya Veramchuk

The term “corporate actions” is well known in traditional finance as an event by a public company that may affect the company’s securities and, consequently, its shareholders and bondholders. Examples include making a change to a company’s name, issuing a dividend, or even restructuring through a merger or bankruptcy. These transactions are familiar, have an established framework, and can be categorized and analyzed for different purposes, including taxation. 

However, the crypto ecosystem has introduced completely novel event structures to this framework that are highly focused on decentralized technology itself and can occur faster or more unpredictably. It is difficult to fathom a publicly-traded company splintering off into over 100 distinct entities with competing goals, but we know in the digital world, Bitcoin birthed more than 100 hard-forked assets in the 2010s. The dynamic and unprecedented ways in which digital assets can change and transform have brought a huge challenge to market participants: how does one categorize, analyze and prioritize events like hard and soft forks, migrations, airdrops, burns… and the list goes on. 

In addition, without a source of standardization, events as simple as ticker symbol changes may potentially create certain reporting issues for users.  The lack of consistency in how changes are tracked can lead to materially inaccurate tax lot matching, where such lots are created across entities using different ticker symbols to represent the same asset or, alternatively,  the same ticker symbol is utilized to represent different assets. This can make something as simple as applying a lot relief methodology challenging or not possible without first applying reference mapping data.  Bitcoin fork history illustrates the nearly impossible task of tracking newly formed assets and their respective naming conventions.

Just as in traditional finance, some “crypto action” events (as we call them at Lukka) are more impactful than others. When looking specifically at assets – rather than entities in the crypto ecosystem – crypto actions can broadly be categorized as either a complete change to an asset’s structure or as a change to its characteristics. Understanding the type and degree of change is important in facilitating analysis of the relevant tax, accounting, and legal implications. Here is a look at some crypto actions and the tax consequences they prompt.

Asset and Blockchain Migrations

Overview

Migrations are a constant occurrence in the digital asset space and can have a variety of effects on the structure of an asset. Assets can migrate from contract to contract on the same protocol and also from one blockchain platform to another, or both. Migrations can occur for multiple reasons, including bringing new assets into an existing product ecosystem, expanding support to new protocols, upgrading asset functionality, or movement of an asset from testing environments to production. 

An example that encompasses several of these scenarios is the migration that Project Hydro initiated last year. In this case, the project was looking to expand its reach and avoid high Ethereum gas fees by migrating HYDRO, its native token, to the BNB Chain. They also intended to respond to community feedback that the total supply was too large by reducing the supply and adding burn functionality to the asset smart contract. This was accomplished in two phases:

  1. Old HYDRO ERC20 tokens in personal wallets were migrated directly for new HYDRO BEP20 tokens at a 100:1 ratio (a migration between two blockchains). 
  2. The remaining old ERC20 HYDRO tokens were swapped for new ERC20 HYDRO tokens at a 100:1 ratio on a per exchange basis (a migration between two contracts on Ethereum).

As a result, there were two new versions of the HYDRO asset on different blockchains, and users who had previously held 100 old tokens now only held 1. The Hydro Project stated that the old HYDRO tokens were now obsolete. 

What this means from a tax perspective  

Generally, under the US tax principles, a realization event would occur when two conditions are met: there is a sale or exchange of assets, and the asset received is materially different in kind or extent from the asset given up1. Every instance should be reviewed on a standalone basis to determine whether there is a taxable event or not because the difference in the fact pattern may result in different tax treatments.

Consider moving an asset from the testing environment to production. It is unlikely that any assets are exchanged or there are any new features added. Consequently, it probably shouldn’t be treated as a taxable transaction. Similarly, enhancing existing assets with some new capabilities or improvements but not exchanging the original token iterations for the new and improved ones should not give rise to tax. 

However, an asset swap with a migration to a new blockchain would likely yield a different result. The HYDRO migration example outlined above clearly shows that the original tokens were exchanged for the new tokens at the 100:1 ratio. Further, because the new tokens had new capabilities as compared to the original tokens, it is reasonable to suggest that they were materially different from the original tokens. Thus, both realization requirements were met, resulting in a taxable exchange for the token holders. 

There are many other examples that are much grayer than the ones discussed. For instance, certain exchanges offer swapping ERC-20 versions of digital assets for the native ecosystem tokens (consider KuCoin facilitating the KAI swap). Note that this is slightly different from the so-called backdoor bridging offered by some centralized exchanges. There, the investors could deposit or buy tokens on one blockchain but withdraw them on a different blockchain. The key differentiator between a migration and a backdoor bridge is that a migration is an infrastructural change and not a permanent pathway designed to facilitate financial trading. 

The views on taxation of such ERC-20/native tokens swap vary. Some tax practitioners believe it is unreasonable to treat such swaps as taxable trades because the investor retains the benefits and burdens of owning the asset, and thus there is no exchange for tax purposes. We have discussed this issue in detail in our earlier blog.  

Other tax experts take a more literal view of the transaction and consider it an asset-for-asset exchange. Further, they look to the like-kind exchange guidance issued by the IRS last summer2, where the IRS maintained that every blockchain was “fundamentally different from each other.” Consequently, if an asset migrates from one blockchain to another, then it would likely gain new capabilities and therefore be materially different, resulting in a taxable transaction. There is no formal guidance on the matter. Thus, taxpayers are encouraged to discuss any points of contention with their tax advisors. 

Hard Forks

Overview

Hard forks are arguably the most (in)famous events in the blockchain ecosystem. There are many ways in which hard forks can be implemented. They generally involve a change to a single blockchain protocol that makes previous versions incompatible with that protocol going forward. Whether this revision is to implement new features or create an entirely new asset based on an old one, this new branch or “fork” of the blockchain protocol stems from the previous one. 

Although it is often the case, both branches do not need to be “adopted” for an event to qualify as a hard fork. While many hard forks are the result of divergent views on protocol management in which the community must choose which branch to support, many are part of planned upgrades in a blockchain’s development. 

Two very different examples of forking are the London hard fork on Ethereum and the Bitcoin Cash fork from Bitcoin. 

In the case of the London fork, Ethereum was implementing a network functionality upgrade that resulted in a new set of rules for transaction validators going forward. While a new branch of the protocol was created from a technical point of view, the old branch was deprecated, and only one Ethereum persisted in the market. 

The Bitcoin Cash fork from Bitcoin resulted from a disagreement between market participants on how the protocol should operate, thus giving birth to two completely separate assets. In 2017, holders of Bitcoin were credited with Bitcoin Cash when the fork occurred. Users of these crypto assets should consider these differences when analyzing their tax implications.

What this means from a tax perspective

Unlike many other issues in the digital asset space, tax treatment of hard forks was addressed by the IRS in the Revenue Ruling 2019-24, with some subsequent clarifications in the ILM 202114020 and FAQs on Virtual Currency Transactions. 

The IRS defines a hard fork as an event that “occurs when a cryptocurrency on a distributed ledger undergoes a protocol change resulting in a permanent diversion from the legacy or existing distributed ledger” and which “may result in the creation of a new cryptocurrency on a new distributed ledger in addition to the legacy cryptocurrency on the legacy distributed ledger3.” 

Consequently, it is important to distinguish between the events resulting in an airdrop of a new digital currency and those that do not.

Generally, when a hard fork is not followed by an airdrop of a new cryptocurrency, no taxable income should be recognized, and no reporting is needed. The Ethereum London hard fork discussed above is a great example of a non-contentious hard fork. 

In contrast, contentious hard forks followed by an airdrop of the new cryptocurrency result in ordinary income recognition under the current guidance. The assets received should be reported at the fair market value, provided the recipients have dominion and control over such assets, i.e., can, exchange or otherwise transfer them. This is illustrated by the Bitcoin Cash hard fork discussed above. 

To summarize, tax consequences and reporting requirements can vary quite significantly depending on the blockchain event. Therefore, taxpayers should always do the due diligence to understand what, if any, implications would apply.

  1. Treas. Reg. Sec. 1.1001-1(a)

  2. CCA 202124008

  3. Revene Ruling 2019-24

About Lukka

Lukka is a firm that helps solve some of the greatest financial challenges in crypto and has the intellectual resources, along with the data and processing capabilities, to test hypothetical scenarios like the one here. For more information on how Lukka puts data to work across multiple finance sectors, traditional and decentralized, supporting industries from insurance to Formula E, go to our website at Lukka.tech

Beyond Bitcoin, Part 2: Increasing Accessibility Through a Digital Assets Classification System

James McDonald on February 24, 2022

Author: James McDonald, Product Manager in Data and Analytics

In part one of the Beyond Bitcoin series, we introduced the importance of applying a sector classification system to the emerging Digital Assets asset class. We examined what it looks like for an investor to expand their view of the digital assets market beyond the oft-cited Megacap assets (such as Bitcoin and Ethereum) and discussed how a sector classification would benefit portfolio managers making active investment decisions.

This part of the series explores how this will increase access for market participants through the transparency, clarity, and stability that comes from applying a sector classification.

Benefits of Adopting a Standardized Sector Classification

The broad adoption of a digital assets sector classification system has the capability to provide benefits to market participants, supplement the growth of digital assets, and enable new investors to participate in the market. Notable benefits include:

Adding Efficiency to the Portfolio Management Process 

Asset sector categorization allows investors to overlay traditional portfolio management methods within the portfolio construction process. For example, investors could compare risk and return metrics across different sectors as well as examine historical returns to see how specific assets have performed compared to their sector. Going further, investors could study the correlation of returns across sectors with the goal of reducing idiosyncratic risk within a portfolio. 

These types of analyses which are common in mature markets, support the overall portfolio construction process. However, the adoption of similar practices within the digital assets space has yet to come to fruition in the same way it is used in public equities markets, largely due to barriers in classifying digital assets in a standard and consistent way. 

How It Could Work

A hypothetical investor may compare the 12-month historical performance and standard deviation of returns for assets within the Smart Contract Platforms and Scaling sectors. They see that the Smart Contract Platforms sector outperformed the Scaling sector in the last 12 months while maintaining a comparable level of risk. This information, plus a manager-driven macro-level view of the fundamentals within the digital assets market, could inform an investment thesis for overweighting or underweighting an allocation to the scaling sector. 

Creation of New Investment Products 

As the Digital Assets asset class grows and matures, the demand for new products and tailored exposures from market participants continues to increase. Using a sector classification system to build investment products that help formulate tailored exposures in the digital assets market will benefit issuers, investors, and the overall market structure. As regulatory clarity unfolds, investors may see the introduction of products that enable quick exposure to specific corners of the digital assets market.

How It Could Work

Similar to how investors are able to gain exposure to certain sectors via sector-specific ETFs in the stock market today, they may demand similar tailored exposure to digital assets. Investors may choose from an array of products that provide exposure to a specific sector, such as Metaverse ecosystems, Play to Earn tokens, or DeFi platforms, allowing investors to create more diverse and efficient portfolios. 

Enable Index Construction to assist in Benchmarking: 

Adoption of a standardized sector classification system will lead to new digital asset-specific indices. Indices that can offer greater transparency to market participants within the digital assets space as well as provide a standardized point of comparison for benchmarking. Sage index providers recognized this is a critical requirement to advance market maturity. 

A great example of this is the S&P Dow Jones suite of digital asset indices dedicated to helping investors track exposure to different areas of the market. Indices help investors benchmark asset or portfolio performance, compare professional investment managers, and set trackable risk and return goals.

How It Could Work

Self-directed investors could opt to invest in digital assets and gauge their performance against an index that tracks the broader market, such as the S&P Cryptocurrency Broad Digital Market Index (SPCBDM). From another side of the market, a Fund of Funds Manager may look to construct a portfolio of active digital asset hedge funds primarily based on previous performance against the same SPCBDM index benchmark. 

Investor Portfolio Governance and Guideline Supervision

The application of a standardized classification system allows for tailored and rigorous controls in portfolio mandate documentation and subsequent portfolio monitoring. In addition, classification empowers professional money managers and clients to specify more granular controls for investment managers within traditional agreements, such as an Investment Policy Statement or Financial Plan.  

How It Could Work

The client and money manager could agree that no more than 2% of the portfolio value can be allocated to DeFi strategies, and only 5% can be allocated to the Digital Assets asset class. These rules could be crucial for new investors who are hesitant to enter the market due to risk or volatility concerns. The correct implementation of such guidelines will enable a risk-focused approach to entering the market and promote broader adoption.

The underlying theme in all of the above benefits is they make digital assets more accessible for investors. A classification system removes significant barriers to entry for new investors and makes the asset class more digestible at all levels of market participation. Bypassing crypto-jargon and viewing the market via a standardized digital assets sector classification system helps investors understand their investment and increases transparency, stability, and participation.

About Lukka

Lukka is a firm that helps solve some of the greatest financial challenges in crypto and has the intellectual resources, along with the data and processing capabilities, to test hypothetical scenarios like the one here. For more information on how Lukka puts data to work across multiple finance sectors, traditional and decentralized, supporting industries from insurance to Formula E, go to our website at Lukka.tech

DISCLAIMER

THE INFORMATION CONTAINED IN THIS BULLETIN PROVIDES ONLY A GENERAL OVERVIEW OF CURRENT ISSUES RELATED TO DEBT FINANCING IN CRYPTOCURRENCY MARKETS AND SHALL IN NO EVENT BE CONSTRUED AS THE RENDERING BY LUKKA OF PROFESSIONAL ADVICE OR SERVICES. AS SUCH, THE INFORMATION PROVIDED IN THIS BULLETIN SHOULD NOT BE USED BY YOU AS A SUBSTITUTE FOR CONSULTATION WITH PROFESSIONAL ADVISORS. BEFORE MAKING ANY DECISION OR TAKING ANY ACTION REGARDING YOUR DIGITAL CURRENCIES OR THE DEBT TREATMENT THEREOF, YOU SHOULD ALWAYS CONSULT WITH AN APPROPRIATE FINANCIAL, LICENSED TAX, ACCOUNTING, OR OTHER PROFESSIONAL. TO THE FULLEST EXTENT PERMITTED BY LAW, IN NO EVENT WILL LUKKA(INCLUDING ITS RELATED ENTITIES, OWNERS, AGENTS, DIRECTORS, OFFICERS, ADVISORS, OR EMPLOYEES) BE LIABLE TO ANY READER OF THIS BULLETIN OR ANYONE ELSE FOR ANY DIRECT, INDIRECT, OR CONSEQUENTIAL LOSS OR LOSS OF PROFIT ARISING FROM THE USE OF THIS BULLETIN, ITS CONTENTS, ITS OMISSIONS, RELIANCE ON THE INFORMATION CONTAINED WITHIN IT, OR ON OPINIONS COMMUNICATED IN RELATION THERETO OR OTHERWISE ARISING IN CONNECTION THEREWITH.

A Brief Take on the Federal Reserve’s CBDC Report

Suzanne Morsfield on January 20, 2022

The Federal Reserve published a highly anticipated whitepaper discussing the pros and cons of introducing a central bank digital currency (or “CBDC”). The Fed acknowledged that creating a CBDC would “best serve the needs of the United States by being privacy-protected, intermediated, widely transferable, and identity-verified.”

Lukka’s Brief User Guide on Crypto Taxes

Lukka on January 10, 2022

Updated March 2022

2021 has seen unprecedented volumes of digital assets transactions. From cryptocurrency purchases and sales to a myriad of Decentralized Finance (“DeFi”) undertakings, non-fungible tokens (“NFTs”) minting, and trading, all while merchants began to accept payments in crypto. However, as digital assets continue gaining wider recognition and acceptance, it is important to not lose sight of the tax implications from these investments and sales, otherwise, investors would be stuck with a huge tax bill when filing their returns.   

A lot of ink has been spilled discussing digital asset taxes, from the most basic ones to the really nitty-gritty complex tax issues and transactions. This blog provides some important notes on what taxpayers should keep in mind when reviewing their 2021 investment and trading activities. For a deeper dive on many of these topics, some thorough and helpful articles can be found here: 

https://lukka.tech/category/all/tax/

General Principles of Taxing Digital Assets

In 2014, the Internal Revenue Service (“IRS”) issued Notice 2014-21, which stated that cryptocurrency should be treated as property, as opposed to a currency (i.e., euros or USD). This principle generally, but not always, applies to digital assets across the board. 

Absence of tax guidance and diversity of transactions in the digital asset ecosystem often complicate matters. While the IRS has subsequently issued some limited guidance, it still is not part of the formal Internal Revenue Code and the Regulations. This leaves tax advisers and taxpayers alike relying on the existing framework to analyze their activities and compute tax liability. 

Taxable and Tax-Free Transactions

Not every interaction with a digital asset would give rise to taxes. Let’s first look at some examples of transactions that would trigger taxation. Note that neither this list nor any other examples outlined below, are exhaustive by any means and are meant to be used for illustrative purposes only. 

  • Trading digital assets for fiat currency (i.e., USD), regardless of whether the fiat is then subsequently withdrawn from the wallet/exchange or not. 
  • Trading one digital asset for another. This includes trading cryptocurrencies (e.g., BTC for ETH) as well as buying and selling NFTs for crypto. 
  • Receiving tokens as a result of hard forks and airdrops. Such tokens would be subject to tax based on the fair market value at the time of the receipt, assuming the taxpayer has “dominion and control” over the asset, i.e., is able to transfer, sell, exchange or otherwise dispose of the asset. 
  • Receiving mining, staking, liquidity pool and farming rewards, are taxable based on the fair market value at the time of the receipt, with the same dominion and control doctrine applied here. 
  • Buying goods and services with crypto (although individual investors should exercise caution here since personal losses incurred may not be deductible). 
  • Losing one’s borrower collateral in a forced liquidation.

And here are some examples of tax-free transactions: 

  • Purchasing cryptocurrency or an NFT with fiat currency. 
  • Holding digital assets (even if the value goes up exponentially, no tax is due until the asset is disposed of).
  • Moving digital assets between wallets and exchanges. 
  • Gifting digital assets or receiving them as a gift (provided the total value of such a gift is below the annual gift tax exclusion, $16,000 in 2022). It is important to note that the recipient of the gift would inherit the giftor’s cost basis and holding period. 
  • Inheriting digital assets (although if the value of the estate exceeds $12.06 million in 2022, then such assets may be subject to estate taxes). Similarly to stocks, the inherited digital assets would get the cost basis step up to the fair market value on the day of death. 
  • Making a charitable contribution (although there are certain reporting requirements that must be adhered to, depending on the size of the donation). 

There is a great deal of uncertainty with respect to the treatment of many DeFi activities. An argument can be made for both tax-free and taxable treatments in a number of instances, including, but not limited by, the following: 

  • Wrapping tokens (e.g., ETH for wETH) to allow additional functionality
  • Contributions to and withdrawals from liquidity pools 
  • Bridging multichain assets from one blockchain to another 
  • Participating in liquid staking offerings 

Income Character

Because digital assets are treated as property, they are considered to be capital assets. Some of the key issues to consider here are as follows: 

  • Disposition of capital assets gives rise to a capital gain or a capital loss (as opposed to ordinary income).
  • Gains realized on assets held over one year are eligible for the preferential long-term capital gain treatment and are taxed at lower rates than short-term capital gains (for individuals). 
  • Gains realized on assets held for less than a year are taxed as short-term capital gains at the same rate as the ordinary income (i.e., wages, interest, dividends).
  • The IRS permits for a variety of the lot relief methodologies, namely first-in first-out (“FIFO”), last-in first-out (“LIFO”), highest-in first-out (“HIFO”), and specific ID (taxpayer specifically identifies the lots they wish to dispose of). This means that if taxpayers have acquired and disposed of multiple units (or lots) of a given cryptocurrency, they need to take a comprehensive look at their overall portfolio and make a strategic decision with respect to the lot matching methodology they wish to employ. Given the general volatility of crypto, the results derived under each method can vary significantly. It is worth noting that the average cost basis method is likely not permitted for digital assets. 
  • Transaction fees do not get lost. Instead, they increase the cost basis of the purchased asset and decrease the sales proceeds.
  • Generally, individual taxpayers are permitted to net capital gains and capital losses. If there is an excess capital loss, then up to $3,000 can be used to offset the ordinary income. 

However, not every interaction with digital assets would give rise to capital gains. For example, where a taxpayer receives airdrops, staking, or mining rewards, the IRS considers such rewards to be of ordinary character. Lost or stolen crypto would generally result in a capital loss (potentially unavailable to the individual investors) but abandonment of a scam coin would have the ordinary character. An NFT sold by an investor would result in a capital gain or loss, but an NFT sold by a digital arts dealer would yield ordinary income. 

Conclusion

As the digital asset ecosystem continues to evolve, so will the complexity of transactions. This blog highlights just a few examples, at a high level, and those watching tax rules change should note that the speed of the evolution of the assets will far surpass the speed of updated, relevant tax guidance. 

As tax season ramps up, taxpayers need to ensure that comprehensive records of all transactions are readily available, the transactions are appropriately classified (either as capital or ordinary income), and any relevant limitations are considered for the more complex or controversial transactions.

The biggest names in finance trust Lukka products to solve the back end challenge of valuing assets accurately, and reliably enough to stand up to an audit. Learn more about ways you can track valuation throughout the year and especially during tax season.

The information contained in this bulletin provides only a general overview of current tax issues related to staking and shall in no event be construed as the rendering of professional advice or services. As such, the information provided in this bulletin should not be used as a substitute for consultation with professional advisors. Before making any decision or taking any action regarding your digital currencies or the tax treatment thereof, you should always consult with an appropriate, licensed tax, accounting, or other professional. To the fullest extent permitted by law, in no event will Lukka, Inc. (including its related entities, owners, agents, directors, officers, advisors, or employees) be liable to any reader of this bulletin or anyone else for any direct, indirect, or consequential loss or loss of profit arising from the use of this bulletin, its contents, its omissions, reliance on the information contained within it, or on opinions communicated in relation thereto or otherwise arising in connection therewith. 

CEO of Lukka, Robert Materazzi, appears on the Crypto 101 Podcast

Lukka on December 27, 2021

Lukka’s CEO, Robert Materazzi, recently discussed how Lukka is becoming the crucial backbone of crypto on the Crypto 101 podcast. Robert and host Bryce Paul discussed the complexities crypto native companies and traditional finance face when interacting in the crypto ecosystem.

The pair covered the specific data difficulties businesses face when trading digital assets, including crypto. Robert explained the need for accurate, complete data and how Lukka offers software solutions to organize data securely and accurately.

Robert also spoke to the changing regulatory and risk landscape businesses need to consider when managing risk, especially as digital assets face further scrutiny from governing bodies. He outlined the critical role regulators and standard setters face in supporting innovation and shaping the ecosystem’s future.

When Robert was asked what he sees as one of the biggest challenges for the industry moving forward, he highlighted the need for businesses entering the crypto ecosystem to educate themselves on how the space is changing. For businesses and consumers who want to learn more about crypto, Lukka Library is a content database filled with resources authored by some of the industry’s foremost thought leaders on crypto tax, regulation, and other foundational subjects.

To listen to the full podcast follow the link below:

Ep. 404 – Becoming the Crucial Backbone of Crypto with Robert Materazzi of Lukka

Lukka’s Head of Accounting Solutions, Suzanne Morsfield, on the Valuation of Crypto Assets

Lukka on December 15, 2021

Lukka’s Head of Accounting Solutions, Suzanne Morsfield, spoke at the World Continuous Auditing and Reporting Conference with Robert Hertz, a Lukka advisor and former Chairman of the Financial Accounting Board, about valuation of cryptocurrencies.

The two explored the accounting and valuation challenges presented by assets in the crypto ecosystem. Suzanne noted that aspects of traditional accounting like market close, standard ticker symbols, and regulation are absent from the crypto ecosystem, adding complexity to accounting processes. Robert noted the accounting challenges that stem from inaction by standard-setting boards considering how to address crypto, and how attuned the accounting community is to anticipated formal guidance.

Both experts explained how Lukka addresses these challenges using Lukka Prime. Suzanne covered how the Lukka Prime methodology identifies the principal market, and identifies a fair value-based exit price to accurately value every asset. To learn more about Lukka Prime and its methodology, read Lukka’s whitepaper on the subject.