Overview
In this AMA episode, Taariq Lewis @LewisTaariq, CEO of VolumeFi (volume.finance), is joined by special guest Kirk Phillips @thebitcoincpa, a US-based Crypto Tax Accountant and Specialist who navigates the complex world of accounting and tax treatments in crypto.
They discuss the difference between taxes applied to capital gains and ordinary income. Gains from self-custody bots, arguably crypto’s secret tax weapon, while vulnerable to capital loss, are still the preferred category for their lowest tax rates. Self-custody bots like Paloma’s Squeeze bots produce the most coveted capital gains.
Fees derived by liquidity providers are treated as ordinary income and, therefore, subject to generally higher tax rates, including the potential burden of divergence loss.
While opportunities to earn profits and passive income are abundant in the crypto space, mindfulness of tax implications on returns remains paramount.
Definitions
- AMA - Ask Me Anything
- Capital gains - profits from the sale of a capital asset, such as shares of stock, a business, a parcel of land, or a work of art. They are generally included in taxable income but, in most cases, are taxed at a lower rate.
- DeFi staking - refers to immobilizing cryptocurrency assets within a smart contract, yielding rewards, and fostering passive income.
- wBTC - or wrapped Bitcoin, a token representing Bitcoin on the Ethereum network. It provides a way of using Bitcoin in smart contracts and makes the world’s largest cryptocurrency more accessible on decentralized exchanges.
- Divergence loss - happens when the price of your deposited assets in a liquidity pool changes compared to when first deposited. The bigger the change, the more likely you will experience divergence loss.
- Impermanent loss - refers to the temporary loss of value when a user provides liquidity to a decentralized exchange or yield-farming protocol. Termed ‘impermanent’, this loss is only realized if the user withdraws the assets from the pool.
- Long (position) - a market position when an investor buys cryptocurrency or other assets, intending to sell them when the price increases.
- Loss Carryforward - refers to an accounting technique that applies the current year’s net operating loss to the future years’ net income to reduce tax liability.
- LP - or crypto liquidity provider, is an individual or entity that supplies a decentralized finance platform with capital in cryptocurrency assets. DEXs depend on LPs to contribute their digital assets to maintain liquidity.
Intro
Taariq welcomes Kirk to Volume’s Twitter Spaces. He opens the conversation by asking the guest about the tax treatment for bots in crypto.
“These bots are where you put in what you want the bot to do, and how you want to execute the transaction. It’s your money. It is not pooled with anybody else’s. Nobody’s investing for you, so you’re not investing in a fund. You’re not investing in a token. You are putting your money to work. How do you see tax treatment differing for this type of activity?”
Kirk replies that this is a self-custody bot where traders use their funds.
“It’s your own funds that you get to self-custody and that’s the essence of crypto.”
Tax as a Risk
Kirk prefaces the topic with his take on tax: Tax as a strategy and tax as a risk. While some may consider tax a necessary evil, it becomes a risk when folks do not put more thought into it.
“Tax can be a risk to those who aren’t paying attention.”
He talks about what people desire regarding taxable income in many jurisdictions. He defines capital gains as profits from selling capital assets such as securities, stocks, and bonds.
Capital Gains as the Holy Grail of Income
According to Kirk, capital gains are the most coveted type of income, as opposed to ordinary income.
“It’s the golden type of income. Capital gains generally have the lowest tax rates. On the opposite end of the spectrum, you have ordinary income which is generally taxed at the highest marginal rates”.
He explains that the US has a graduated tax rate system, like many other tax systems around the world. Taxes are applied using different tiers. Lower incomes have a lower tax rate, and the higher the income, the higher the tax rate.
Kirk underscores that ordinary incomes are taxed at the highest rates, while capital gains are taxed at the lowest.
“Capital gains are the coveted, golden income bucket that’s typically taxed at the lowest rate.”
He cites the US capital gains tax, for example, which has a 0% tranche, 15%, and 20%. He compares the taxes applied to capital gains versus ordinary income.
“So even at 20%, that is a great category, especially if you otherwise have ordinary income in the highest tax bracket, which could be close to 40%.”
In the U.S., taxpayers could pay twice as much on their ordinary income at 40%, while their long-term capital gains are taxed at 20%.
Bot Gains Versus Liquidity Provider Fees
There are many ways to earn crypto income, including gains and losses. Kirk mentions that in the early days of crypto, you could only buy, hold, or trade. When DeFi staking and the many other ways to generate income in crypto came into play, accounting and tax treatment became quite complex.
He uses the wBTC Squeeze bot as an example. The user supplies wBTC with the desired amount of leverage, and the bot is pre-programmed to make trades and do all the heavy lifting.
“The bot is trading while you sleep, which means it’s just creating capital gains on your behalf, the most desired lowest-taxed type of income. Now, it could have capital losses, but either one of those is still in the preferred category.”
The best way to understand the value of bot gains is to look at its opposite. The trader takes two assets from a liquidity position and provides liquidity to a decentralized exchange or DEX. This becomes the capital used by other people to trade with. Liquidity providers earn fees when supplying capital. These fees can run from 25% to 50% or even higher. Kirk explains the downside.
“The problem is those fees are treated as ordinary income, which is the least desired type of income, that could be taxed at the highest rate.”
Another downside for liquidity providers is divergence loss or impermanent loss. He cites an example where a liquidity provider has a USDC stablecoin and SOL, Solana’s native token.
“Your mouth waters from a high yield percentage so you supply both of those assets to earn fees. That stablecoin is not going to go up or down. Meanwhile, the SOL price will go up or down. When SOL increases in value, some of it’s going to get sold off to rebalance the pool. So then you end up with more stablecoin and less SOL. If the price of SOL goes down, conversely the opposite happens. The problem is the rebalance will most likely not work in your favor.”
If the user takes a long position on SOL, the USDC/SOL will likely work against the liquidity provider burdened with divergence losses and create fees taxed at higher ordinary income tax rates. He adds that capital losses cannot be used to offset this type of income.
The Value of Coveted Capital Gains
Bots will continue to make automated trades, and users will look to close their positions for a capital gain.
“You started with $X on a given day, and you end up with $Y. The difference between those is a gain, and it’s just a matter of whether it’s short term or long term.”
Kirk states that a capital loss from any source can still be offset with freshly minted capital gains. This is not the case for ordinary income from liquid provider fees. He further explains that many people have a ton of loss carryforwards from the recent bear market, especially in the US, where capital losses are limited to only $3000 per year.
“Let’s say you had $150,000 of capital losses. The next time you grab $150,000 of capital gains, it’s tax-free. If those gains were instead ordinary income from LP fees you could end up with a $60,000 in federal tax liability.”
He reminds everyone that bots are typically a short-term strategy producing short-term capital gains that default to ordinary income tax rates.
“However, they are still capital gains and always have an advantage over ordinary income like LP fees, even though both are taxed at ordinary income rates.”
In the ever-evolving crypto landscape, users must always look for places to take capital gains to offset capital losses and end up with tax-free gains.
DEX Liquidity Provider Versus Self-Custody Bots
Taariq and Kirk compare the two degen strategies: DEX liquidity provider versus the self-custody bots.
DEX liquidity providers should be prepared for divergence loss and may be prone to tracking and tax calculation challenges. Earned trading fees will be taxed higher as they are considered ordinary income. On the other hand, self-custody bots enable adjustable leveraging, relative ease in tracking and tax calculations, and more passive management. Most importantly, self-custody bots produce the most coveted capital gains.
Closing
While the crypto space offers abundant opportunities to earn profits, users should always be mindful of the tax implications on their returns. Kirk offers this final advice.
“If you think about crypto returns without a tax mindset, you’ll get tax rekt. Don’t do that. Increase your returns by grabbing opportunities and thinking about tax impact at the same time.”
Taariq thanks Kirk for guesting today and his insightful take on taxes and crypto.
Stay tuned for the next AMA!
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