Golden Encyclopedia | Understanding Cryptocurrency Airdrop Tax

Author: Guest Author, Bankless; Compiler: Tao Zhu, Golden Finance

By now, I think everyone knows that the taxman knows about your crypto and wants a piece of your gains.

Given that it is tax season in many countries around the world, we know that this time of year can be particularly stressful for those in the crypto space. The US individual filing deadline is approaching, so we will focus on the IRS rules in this article. However, given that many tax authorities treat cryptocurrencies in a similar way, this is still relevant to everyone.

By the end of 2023, a new meta is very obvious: airdrops. Let's look at some of the pitfalls of airdrop taxes, how to file cryptocurrency taxes, and some tips to avoid being retorted by the taxman.

Crypto Tax Basics

When investing in cryptocurrencies, there are two main types of taxes you need to understand: capital gains tax (CGT) and income tax. To keep it simple, a capital gains tax event occurs when you dispose of a crypto asset, and an income tax event occurs when you earn profits in a manner similar to income.

Here is a basic list of some events that fall into each category:

Capital gains tax

• Profits from selling cryptocurrencies;

• Profits from trading cryptocurrencies (for example, exchanging BTC for ETH);

• Using cryptocurrencies to purchase goods or services;

• Profits from trading NFTs.

Income Taxes

• Airdrops;

• Staking Rewards;

• Hard Forks

• DeFi/Rewards;

• Mining

• Wages Paid in Crypto

Given the number of airdrops over the past 12 months, we’ll focus on taxes specifically on the airdrops themselves.

Tax Implications of Airdrops

If you’ve been airdropping across different protocols and chains, it’s important to understand what your activities may mean for tax purposes.

While the IRS has yet to issue specific guidance on many of the nuanced cryptocurrency transactions that exist, there is enough available information to infer how they treat specific situations for tax purposes.

You’ve probably deposited cryptocurrency into at least one smart contract, whether for staking, mining, providing liquidity, or something else. Whatever you’re doing, it’s important to know that the IRS may view it as a disposition event, triggering a capital gains tax event.

While there is no specific guidance on smart contract deposits, the question comes down to beneficial ownership. If you no longer control the tokens after making the deposit, the IRS may consider it a disposition event.

Let’s consider the following scenario:

Suzan, an avid airdrop participant, decides to stake 10 ETH in a staking protocol. She initially purchased ETH for $20,000, and at the time of her deposit, its market value was $25,000.

Suzan considers whether she retained beneficial ownership of the ETH during the deposit period and decides that she did not. Therefore, she treats the deposit as a disposition, triggering a $5,000 capital gain.

In the absence of specific guidance, you generally have two options: take a conservative path and avoid penalties, or take a more aggressive stance and risk potentially having to refile and pay a penalty.

If you take a more aggressive stance, you will need to have a reason to support your claim. It is highly recommended that you consult with a tax professional before going down this path.

It is important to remember that many smart contracts will also provide you with a receipt or LP tokens in exchange for your deposit. The IRS has clear guidance that crypto-to-crypto transactions trigger capital gains tax (CGT), so it may be difficult for you to take a different approach if you are in this situation.

If you are one of the many people who have conducted hundreds or even thousands of smart contract interactions through airdrops, you may be thinking about the accounting nightmare you have on your hands. Don’t stress. We have outlined some options below to help you sort out your taxes so that you can rest easy.

How are airdrops taxed?

Let's explore the airdrops themselves. The key point about airdrops is that the IRS considers them to be taxable income at the market value at the time of receipt.

Continuing with the scenario above:

The protocol that Suzan used to stake her ETH has decided to reward users, and she is eligible to claim 1000 tokens. Suzan goes to the airdrop portal and claims the tokens when she receives them in her wallet, which have a market value of $15,000.

In this case, the IRS considers Suzan's income to be $15,000.

Suzan decides to keep the tokens, and their value slowly decreases. Ultimately, Suzan decides to cut her losses and sells the tokens for $5,000 during the same financial year.

In this example, Suzan triggers a CGT event and loses $10,000. This is calculated by subtracting the proceeds of the sale from the value of the tokens when Suzan first received them in her wallet.

For the rest of the financial year, Suzan does not engage in any further cryptocurrency activity. She receives a $5,000 gain from her staking deposit and loses $10,000 from selling the airdropped tokens, leaving her with a net capital loss of $5,000.

The Hidden Trap of Airdrop Mining

Despite a $5,000 capital loss and only taking $5,000, Suzan still has to pay taxes on $12,000 of income. How can this be?

The IRS only allows Suzan to deduct $3,000 worth of capital losses from her income each fiscal year. This leaves Suzan with $12,000 of income to pay taxes, even though she only deposited $5,000 from the airdrop tokens.

This is the hidden trap of airdrop mining (and many other income-generating cryptocurrency activities). If Suzan received more airdrops, or if the tokens fell further, the situation could get even further out of control.

In some cases, investors owe more in taxes than the value of their entire portfolio. When it comes to airdrops or any other cryptocurrency income, it's important to set aside enough money to pay taxes right away so you don't end up in this situation.

Avoid Crypto Tax Nightmares

Crypto taxes can be a maze even in the best of circumstances, but if you’ve been actively doing airdrops, you could be in for a nightmare if you don’t do it right.

It’s common for crypto practitioners to have multiple trading accounts and hundreds of wallets on a ton of new chains. For tax purposes, you need to have a record of all your transactions, otherwise the numbers won’t add up and you could end up overpaying taxes.

You have a few options. One is to manually calculate the taxes yourself, which may be the best option if you’re just tracking some basic buys and sells on one or two exchanges. On the other hand, consulting a tax professional may be your best option if you have complex assets and need to discuss where to start.

Calculating taxes on cryptocurrency can be daunting, but don’t procrastinate or subject yourself to misery.