Wrapped tokens are becoming more commonplace in the crypto world as investors want to use cryptocurrencies across different blockchains. But what is a wrapped token and is it taxable?
Cryptocurrencies exist on different blockchains. This limits which cryptocurrencies can be used on a given blockchain. For example, investors couldn’t trade BTC on Ethereum or ETH on Binance Smart Chain because the coins can’t just be transferred between the two.
Wrapped tokens were created to resolve this issue and allow investors to use coins on different blockchains.
We’re looking at how they work and what you need to know for your taxes.
A wrapped token is a tokenized version of another cryptocurrency, so it's a token pegged to the value of the asset they represent. 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.
Every single wrapped token 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.
As with many newer crypto phenomena - most tax offices haven’t given official guidance on wrapped tokens.
However, there’s no reason to think that wrapped tokens would be treated any differently than any other cryptocurrency from a tax perspective. Cryptocurrency is subject to Income Tax or Capital Gains Tax depending on the type of transaction. For wrapped tokens, it will be Capital Gains Tax we are concerned with.
In most countries, you’ll pay Capital Gains Tax on any profits whenever you ‘dispose’ of a crypto asset by:
When you wrap a coin, you exchange one crypto for another. In most countries, this would be viewed as a kind of disposal - you’re swapping your crypto. Similarly, when you unwrap your coin, you’re exchanging one crypto for another again.
This said, it’s only the profit from a disposal that is subject to Capital Gains Tax. When you exchange a coin for a wrapped token - it is of equal value (or practically the same value). So if you’ve acquired an asset for the purpose of wrapping it, chances are the FMV of the asset won’t change much before you exchange it for your wrapped token.
Of course, if you’re exchanging an asset that has significantly changed in value since the time you acquired it - you’ll have a significant loss or gain to record. For example, if you bought 1 BTC for $30,000 and then exchanged it for 1 WBTC when the FMV of BTC was $60,000 - you’d have a capital gain of $30,000 which would be subject to Capital Gains Tax.
This means investors should avoid using assets which have significantly increased in value as underlying assets for wrapped tokens.
So the good news is, any Capital Gains Tax you do pay on wrapped tokens is often going to be a small sum if you play it smart. The bad news is that even with this in mind, you still may still need to report it to your tax authority.
It’s also worth noting that while almost all tax offices view exchanging one crypto for another as a taxable event, there are a select few that don’t - like France. You should always check your country’s crypto tax rules.
If you’re using wrapped tokens to invest in various DeFi opportunities like liquidity mining, yield farming or more - many of these transactions will be subject to tax, regardless of the cryptocurrency you’re using. Check out our DeFi tax guide for more information on how these transactions are taxed.
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. There is an option to turn this off in settings.
Koinly doesn’t just deal with wrapped tokens though, it can calculate all your crypto taxes for you for all your transactions and provide you with one simple tax summary, with a range of tax reports available to download and submit to your tax office.