What is a Stablecoin and How is it Taxed?

Stablecoins are booming in the crypto world, with the market valued at $130 billion. Learn what stablecoins are, how they work, and stablecoin taxes.

The cryptocurrency market is infamously volatile. Record highs followed by record lows aren’t out of the ordinary and something as simple as Elon Musk tweeting can make waves. For some crypto investors, the gamble is what makes the market so enticing. For others… not so much.

This is where stablecoins come in. They hope to bring more stability to the crypto market for investors and have gained some serious traction.

What is a stablecoin?

A stablecoin is a particular type of cryptocurrency that is “pegged” to a more stable reserve asset. Reserve assets are assets with real-world value, like fiat currencies or precious metals like gold.

How stablecoins work

The way each stablecoin is backed works a little differently depending on what reserve asset they’re tied to. Sometimes it’s achieved through algorithms that steady price fluctuations by limiting or increasing supply. Other times - like when a stablecoin is backed through fiat currency - it’s as simple as holding a dollar in collateral for every coin.

Because these reserve assets are centralized, this results in fewer price fluctuations and less risky investments compared to unpegged currencies, like Bitcoin.

Different types of stablecoins

Stablecoins work slightly differently depending on the asset they’re backed by. To further confuse things, in some instances, there’s no reserve asset at all!

We’ll look at the four most common types of stablecoin to explain this:

• Fiat-backed stablecoins

• Precious metal-backed stablecoins

• Crypto-backed stablecoins

• Algorithmic stablecoins

Fiat-backed stablecoins

Fiat-backed stablecoins are the most common type of stablecoin and one of the most popular. Examples of popular fiat-backed stablecoins include Tether (USDT) and USD Coin (USDC).

These coins basically work as an IOU. You use your one dollar (or any other fiat currency) to buy one stablecoin. You can later redeem your one stablecoin for one dollar. Because the collateral is held, the price of fiat-backed stablecoins doesn’t fluctuate much.

Precious metal-backed stablecoins

Precious metal-backed stablecoins use reserve assets like gold, silver, and other precious metals to help stabilize their value. The downside of these coins is that they are centralized, so many crypto investors avoid them.

Examples of precious metal-backed stablecoins include PAX Gold and Digix. Gold has been seen as a good investment by traditional investors for a long period of time and these stablecoins allow crypto investors access to the market without having to use traditional centralized trading markets.

Crypto-backed stablecoins

Crypto-backed stablecoins use other cryptocurrencies as a reserve asset. This can sound a little bizarre at first due to the volatile nature of cryptocurrencies.

However, most reputable crypto-backed stablecoins are overcollateralized to stabilize value. So if you have a $1 crypto-backed stablecoin, the underlying crypto asset it is backed with would be worth $2. This means if the underlying asset loses value, there is a built-in cushion so the stablecoin’s price is less likely to fluctuate.

Good examples of crypto-backed stablecoins are Dai (DAI) and Wrapped Bitcoin (WBTC).

Algorithmic stablecoins

Algorithmic stablecoins are the ones we referenced earlier that confusingly aren’t backed by any reserve asset at all. They’re also sometimes known as non-collateralized stablecoins.

Instead, algorithmic stablecoins use computer algorithms to control price fluctuations. For example, let’s say an algorithmic stablecoin’s price was set to $1. If the price rises higher, the algorithm will increase the supply of coins to bring the price down. If the price falls lower, the algorithm will cut the supply to bring the price back up.

An example of an Algorithmic Stablecoin is AMPL or TerraUSD.

Why buy stablecoins?

There are a lot of reasons stablecoins have attracted so many crypto investors beyond attempting to minimize volatility.

Stablecoins work exactly the same as other cryptocurrencies, so they have similar appeal with less of the downsides. Crypto investors can use stablecoins to send and transfer money with minimal fees compared to banks. These transactions are also completed in a much quicker timeframe than bank transactions thanks to the underlying technology.

The lack of volatility means stablecoins are a great place to invest and hold your assets, essentially creating crypto savings.

Finally, you can also earn interest from stablecoins by loaning them through DeFi platforms.

Of course, there are two sides to this coin. As we've learned only recently after the TerraUSD collapse - even stablecoins aren't without their risks. You should always do due diligence and research into any projects and only invest what you can afford to lose.

Stablecoin taxes

Stablecoins are taxed just like any other cryptocurrency.

Even though they’re often pegged to a fiat currency like USD, they’re still viewed as an asset by the vast majority of tax offices around the world. This makes them subject to either Income Tax or Capital Gains Tax, depending on the type of transaction you’re making.

You’ll pay Income Tax on your stablecoins when you’re seen to be “earning them” - like an income. This varies depending on where you live but in general, you’ll pay Income Tax if you:

• Get paid in stablecoins - like a salary

• Mine stablecoins

• Receive stablecoins through an airdrop

• Earn interest from your stablecoins

You’ll pay Capital Gains Tax on your stablecoins anytime you:

• Sell your stablecoins for fiat currency.

• Swap your stablecoins for another cryptocurrency.

• Spend your stablecoins on goods or services.

• Gift your stablecoins to a friend or family member (in most countries).

Is converting crypto to stablecoins a taxable event?

If you're wondering, is converting BTC to USDT a taxable event? The answer is a resounding yes. This does vary depending on where you live, but in general, you'll need to pay Capital Gains Tax whenever you convert crypto to stablecoins or vice versa.

You’ll only pay Capital Gains Tax on any profit you make from these transactions. Of course, due to the steady nature of stablecoins - quite often you won’t actually end up paying Capital Gains Tax on these transactions as you won’t be seen to be making a profit. We’ll explain with an example.

It’s really important to declare these transactions even if you have no profit or loss. Of course, stablecoins fluctuate less, but they do still fluctuate in price, so even if you have minimal profits or losses to declare, you still need to.

There are some tax free transactions you don’t need to declare. These include:

• Buying stablecoins with fiat currency.

• Transferring stablecoins between your own wallets.

• HODLing stablecoins

Calculate stablecoin taxes with Koinly

Koinly is a cryptocurrency tax calculator that does all the hard work for you, so all you need to do is download your tax report and submit it to your local tax authority.

Koinly treats stablecoins the same as any other cryptocurrency. All you need to do is sync the wallets and exchanges you use through API or CSV file import and Koinly does the rest. It’ll calculate your capital gains and losses, income and expenses, and compile this into an easy-to-read tax report summary and a variety of tax reports you can download and submit to your tax authority.