What is Bridging Crypto?
Bridging crypto has become more commonplace as blockchains attempt to resolve interoperability issues - but what are the tax implications of bridging crypto?
What is bridging?
Blockchain bridging facilitates the movement of assets between different chains, enabling users to transfer assets from one blockchain to another. As the number of blockchains grows and DeFi users seek to capitalize on various opportunities, bridging has emerged as a necessary transaction type.
Bridging typically involves multiple transactions and may involve converting the underlying asset into a pegged or wrapped derivative, depending on the bridge and the source/destination chain.
Types of bridges
There are various types of blockchain bridges, each serving distinct purposes and functioning differently. Here are the primary types:
Cross-chain bridges: Cross-chain bridges enable the exchange of assets or data between two blockchain networks with different protocols and technologies. For instance, they facilitate the transfer of tokens from the Ethereum network to the Bitcoin network.
Sidechain bridges: Sidechain bridges facilitate asset or data transfers between a main blockchain network and a sidechain. Sidechains are separate blockchains pegged to the main blockchain, often used for specific functions or experiments without impacting the main blockchain.
Federated bridges: Federated bridges are operated by a group of trusted parties, known as a federation. They validate and facilitate asset or data transfers between two blockchain networks.
Hashed timelock contracts (HTLCs): HTLCs are smart contracts enabling trustless asset or data transfers between two parties. The transfer occurs only if the recipient can provide cryptographic proof of receiving the assets or data.
Programmable token bridges: Programmable token bridges merge token bridging with arbitrary data messaging capabilities. They facilitate the transfer of not only tokens but also various data types between blockchains, enabling complex functionalities like swapping, lending, staking, or depositing tokens in smart contracts on the destination chain.
Trust-minimized bridges: Trust-minimized bridges offer the highest level of trust minimization guarantees, albeit they may be less flexible and more computationally expensive. These bridges are commonly utilized in use cases requiring utmost security and trust.
What's an example of a crypto bridge?
The Polygon Bridge serves as an interoperability solution between blockchain networks, primarily enabling the seamless transfer of tokens from the Polygon network, an Ethereum-compatible framework, to the Ethereum mainnet.
What are the benefits of bridging?
A blockchain bridge acts as a crucial link connecting distinct blockchains, enabling seamless transfer of data and assets across them. Specifically, a cross-chain bridge facilitates the conversion of a native asset from one blockchain into its equivalent asset on another blockchain.
One of the significant advantages of bridging lies in enhancing the functionality and scope of a particular blockchain. For instance, an enterprise may opt to utilize a permissioned blockchain for internal operations while seeking to harness the enhanced security and transparency offered by a public blockchain. Through the utilization of a bridge, the enterprise can securely integrate its permissioned blockchain with the public blockchain, thereby accessing the advantages offered by both networks.
Moreover, bridging facilitates asset exchange between different blockchains. Consider a scenario where a user on one blockchain intends to transfer a managed digital asset, such as cryptocurrency, to a user on another blockchain. A bridge streamlines this transfer by enabling the asset to be "wrapped" into a recognizable form that can be seamlessly transferred between the two networks.
What are the risks of bridging?
Despite the numerous benefits, bridging in blockchain poses certain risks and challenges. One critical concern revolves around ensuring the security and integrity of the bridge itself, given its pivotal role as a communication gateway between the interconnected networks. A compromised bridge could potentially grant malicious entities unauthorized access to sensitive assets or information. There have been several notable bridge hacks - including a $615 million exploit of Ronin, the bridge supporting Axie Infinity.
Additionally, the concept of finality presents a noteworthy risk. Finality ensures that funds on the destination chain become accessible once committed on the source chain. In the absence of finality, a reversed transaction on the source chain (e.g., block reorganization) could trigger complications on the destination chain, potentially resulting in the creation of unbacked bridged tokens.
Read next: I lost money in a crypto scam, will I be taxed?
What are the tax implications of bridging crypto?
Currently, most tax offices, including the IRS, lack specific guidance on the tax implications of bridging crypto assets. As such, it should go without saying that you should speak to an experienced accountant for bespoke advice on your potential tax liability.
This said, two main approaches to crypto bridging tax have emerged:
First approach: Some consider bridging to be a taxable event, viewing the act of bridging itself as a disposal. They argue that when transferring a crypto asset cross-chain, the asset effectively leaves the beneficial ownership of its original holder. This perspective suggests that moving assets across fundamentally different blockchains might create materially different assets, and by enabling the smart contract to conduct this cross-chain journey, the owner relinquishes ownership over their assets.
Second approach: In contrast, the second approach contends that due to the absence of guidelines from tax regulatory bodies, bridging is akin to transferring crypto between two wallets owned by the same user. Therefore, it does not constitute a disposal event, and no capital gains tax would be incurred.
Without guidance, it's advisable to consult with an accountant to determine the most suitable approach based on your individual circumstances.
How Koinly can help with bridging transactions
Koinly is a crypto tax calculator that can handle even the trickiest of transactions - including bridging.
With Koinly, most bridge transfers will be handed automatically and be treated and appear as transfers.
There are a very small number of transactions Koinly may not handle automatically, for example, in instances where you send one asset and receive a wrapped version (i.e. ETH/WETH). In these instances, you can simply select both transactions and select merge.
