Are Wrapped Tokens Taxed?
Wrapped and bridged tokens have become commonplace in DeFi, but they present some challenging tax implications for investors. Learn more in our guide.
What is a wrapped token?
A wrapped coin or token is a tokenized version of another cryptocurrency, so it's a token pegged to the value of the asset they represent. In the context of wrapped coins, this other asset is usually another cryptocurrency. This allows for interoperability between blockchains; for example, you could wrap Ether or Bitcoin to use them on the other blockchain.
Example
A good example is Wrapped Bitcoin (WBTC). 1 WBTC would be the same value as 1 BTC, as it’s pegged to the value of Bitcoin. If the value of BTC changes, so does the value of WBTC. Wrapped Bitcoin can exist on the Ethereum blockchain, whereas Bitcoin can’t.
In this sense, they work in a similar fashion to stablecoins. Except where a stablecoin is most often pegged to the value of a given fiat currency, like USD, a wrapped token is usually pegged to the value of a cryptocurrency that exists on another blockchain.
Though blockchains might sound similar, the underlying software and protocols that govern them are often very different. This means there’s no easy way to move assets between them. Wrapped tokens were created to allow for interoperability between the different blockchains.
In most instances, a user can wrap and unwrap a given token whenever they want; they just need to exchange the token back for the underlying asset.
How do wrapped tokens work?
Every single wrapped coin is backed by an equal amount of the underlying asset.
This is all done through custodians. A custodian in this instance could be a smart contract, a decentralized autonomous organization (DAO), or a merchant. Whichever it is, the custodian is responsible for holding the underlying asset and minting a wrapped token of equal value.
So let’s say you wanted 1 WBTC to use on Ethereum. You’d transfer 1 BTC to the custodian -like BitGo - and they would then mint 1 WBTC on ETH. When you’ve made your desired transactions and you want your BTC back, you’ll put in a burn request to the custodian, and your original BTC will be released.
Are wrapped tokens taxable?
There's limited guidance from the IRS on the tax implications of this transaction, so investors need to interpret the existing guidance as best they can (or better yet, get their accountant to).
When you wrap a token, you exchange one crypto for another, even if the underlying asset the new crypto is representing is the same asset.
This is akin to a crypto trade, which is a type of disposal, even if the underlying asset is the same. Similarly, when you unwrap your coin, you’re exchanging one crypto for another again. This means wrapping and unwrapping your tokens is likely taxable under existing guidance.
That said, it’s only the profit from a disposal that is subject to capital gains tax.
When you wrap a token, you're exchanging it for another token that's of equal value (or practically the same value) on that day. But that isn't how you calculate your profit; you need to factor in your cost basis (how much you originally paid for the token).
Example
You bought 1 BTC for $20,000. This is your cost basis.
You trade your 1 BTC for 1 WBTC. On the day you make the transaction, the FMV of BTC (and WBTC) is $50,000.
To calculate your perceived profit, subtract your cost basis from the FMV. This leaves you with a gain of $30,000, even though you've traded it for the same asset.
This means investors should be careful about which assets they choose to wrap, and consider their cost basis, to avoid any unwanted realized gains.
If you play it smart, the CGT due on any wrapped tokens will be minimal. However, even if this is the case, you'll still need to report it to the IRS as a disposal.
If you’re using wrapped tokens to invest in various DeFi protocols, many of these transactions come with tax implications. Check out our DeFi tax guide for more information on how these transactions are taxed.
Can I claim a capital loss on a wrapped token?
Yes. If you take the same approach above, that any gain from wrapping a token is taxable, then any loss would be deductible.
What about fees for wrapping tokens?
Any transaction fees related to a taxable transaction can be added to your cost basis and included in your calculations for your gain/loss. However, this would not be the case for transfer fees.
How Koinly deals with wrapped tokens
Koinly treats wrapped tokens as a crypto-to-crypto trade, whether you’re wrapping a token or unwrapping it. By default, Koinly realizes gains on crypto-to-crypto trades and calculates your gain for you. Koinly can also generate pre-filled 8949 forms with all your disposals, no matter how small the gain/loss.
