Tax-Efficient Strategies for Highly Appreciated Crypto Investments

As cryptocurrency markets rebound and mature, savvy investors are exploring ways to unlock value from their appreciated holdings—without triggering tax liabilities. Whether the goal is to generate yield, manage risk or achieve tax-efficient diversification, the structuring of crypto transactions is becoming increasingly sophisticated and important. From pledging and lending to staking and exchange funds, investors have more tools than ever to reposition their portfolios, but each carries complex and evolving tax considerations. This article outlines several advanced strategies that can help investors navigate these challenges and optimize outcomes across a dynamic legal and regulatory landscape.

In many instances, this article refers to Bitcoin (BTC) and/or Ether (ETH); however, the strategies discussed herein can generally be applied to most cryptocurrencies.

Crypto Pledges: Using Crypto as Collateral Without Tax Consequences

For investors who want to access capital without selling their crypto, pledge arrangements offer a practical and relatively straightforward path. In a typical pledge, the investor uses cryptocurrency as collateral to secure a loan, while continuing to retain ownership of the asset. In a normal lending transaction, a pledge is not treated as a disposition for federal income tax purposes and, accordingly, taxable gain or loss is generally not recognized upon the receipt of loan proceeds.

But not all purported pledges are treated the same when decentralized platforms are involved and these arrangements are not always as advertised. Therefore, when pledging cryptocurrency through a decentralized platform, investors should ensure their transactions comply with the typical terms of a loan.

Additionally, Bitcoin is generally not compatible with these decentralized platforms as the platforms only accommodate cryptocurrencies that employ digital standards which were adopted after the creation of Bitcoin. Before Bitcoin can be used on these platforms, it must be wrapped. Wrapping involves transferring the Bitcoin into a smart contract which issues a token to the transferor. The token enhances the owner’s ability to transfer or otherwise use Bitcoin in the digital sphere. However, the token does not provide any additional legal rights to the holder relative to holding Bitcoin. Each token represents nothing more than the ownership of the transferred Bitcoin. The token can be burned at any time and Bitcoin will be transferred to the token holder. Wrapping does not shift the benefits and burdens of ownership, so it should not be considered a taxable disposition. 

Crypto Lending: Earning Yield Without Selling

Another option for investors interested in generating yield is to loan cryptocurrency to a third party in exchange for interest payments. Borrowers will typically return identical property but not the same unit of property (e.g., lender transfers one BTC to borrower who later transfers a different BTC back to lender).

The transfer of Bitcoin to a borrower who can (and usually does) sell the borrowed Bitcoin will typically constitute a “disposition” for income tax purposes. However, the transfer of a particular Bitcoin to a borrower followed by the return of a different Bitcoin should be treated as a single transaction (i.e., the transaction constitutes the exchange of two Bitcoins).[i] The exchange of two identical assets should not constitute a taxable transaction.[ii]

Unfortunately, many online lending platforms are not designed with U.S. income tax implications in mind. One must look to the structure of the arrangement to confirm that a taxable exchange does not occur. Many decentralized lending platforms operate through lending pools. Ideally, the structure should provide for an exchange of one fungible asset for an identical fungible asset. An exchange of Bitcoin for a token representing a share of a mixed-asset pool (e.g., Bitcoin and other assets) is more likely to trigger a taxable event, whereas a token representing a share of a pool holding only Bitcoin is less likely to do so. Additionally, the lender must retain all of the benefits and burdens of ownership of the transferred asset. For example, if the digital asset increases or decreases in value, the economic gain or loss should be retained by the lender. Finally, the lender should have the ability to regain possession of the lent asset in a relatively short period of time.

Any interest or other fees paid to the lender during the term of the loan will likely constitute ordinary income. There is generally less risk of a taxable exchange where the interest payments are made directly to the lender on a periodic basis rather than collected and retained inside the pool.

Staking: Understanding the Tax Impact of Staking and Rewards

There are many different types of staking in which a crypto investor could participate. For example, the Ethereum protocol allows holders of Ethereum’s coin (ETH) to stake their ETH and become a validator. Validators can validate new blocks of information for addition to the Ethereum blockchain. A validator that adds new blocks of accurate information to the chain is rewarded with newly minted ETH. This is known as consensus mechanism staking.

Staking assets incentivizes the validator to act truthfully because providing false information could cause the validator to forfeit staked assets. The act of staking ETH in this process should not be a taxable event. Unfortunately, according to the IRS, rewards received from staking ETH are likely taxable as ordinary income once the validator has the ability to sell, exchange or otherwise dispose of the rewarded ETH.[iii]  Despite the IRS’s clear position with respect to staking rewards, some taxpayers continue to take the position that staking rewards are self-generated property and are not taxed until the validator disposes of them.

Investors who do not wish to perform validation services can provide their cryptocurrency to a staking-as-a-service provider who performs the validation services on behalf of the investor. Alternatively, an investor can transfer their ETH into a staking pool. In some cases, the staking pool will provide a transferable token to the investor (staked ETH is not transferable).  

While the staking pool is formed via smart contract and it is not formed as an entity under the laws of any state, it does resemble an entity for tax purposes. That is, the pool involves two or more parties coming together in the pursuit of profit. This type of behavior seems to be the hallmark of a tax partnership.[iv] Accordingly, it is conceivable that tax authorities will assert that a staking pool constitutes a legal entity. Currently, there are no decentralized platforms known to provide the type of tax reporting business entities are required to provide (e.g., staking pools do not provide Schedules K-1 to investors).  

While tax practitioners may find the mere creation of a staking pool to be overly complicated or risky from a tax perspective, blockchain innovators are pushing the envelope further by asking: Can one transfer appreciated ETH to a staking pool in exchange for a transferable token and then pledge or stake the token without triggering a taxable sale? Unfortunately, there is limited guidance in this area and the tax implications are highly fact-dependent.

Exchange Funds: Diversifying a Concentrated Position Tax-Effectively

In lieu of generating yield, holders of a concentrated position in an appreciated cryptocurrency can potentially use exchange funds to diversify their holdings. Exchange funds are generally formed as limited liability companies (taxable as partnerships) which accept in-kind investments in the form of cryptocurrency. For example, a Bitcoin investor could transfer their position to a limited liability company in exchange for a membership interest while other investors transfer other cryptocurrencies and/or cash for their membership interests. In this way, our investor has converted his concentrated position in Bitcoin into an indirect interest in a pool of diversified crypto assets. The formation and capitalization of the fund are generally tax-deferred transactions.[v]

If the fund were to sell the Bitcoin contributed by our investor, any built-in gain recognized on the sale would be allocated to the contributing investor.[vi] In other words, the investor only achieves tax deferral through the date that the fund sells the contributed Bitcoin. Accordingly, it is critical that the parties enter into an agreement pursuant to which the fund is restricted from selling the assets for some period of time.

A distribution of property (other than the contributed Bitcoin) within seven years could result in the recognition of the investor’s built-in gain with respect to the Bitcoin at the time of contribution.[vii] After seven years, a pro-rata distribution of the fund’s assets should be a tax-deferred transaction.[viii] This waiting period can be a meaningful hurdle for some investors, and should be weighed against liquidity needs and investment horizons. Therefore, a lock up period of more than seven years and an investor option to receive a pro rata redemption distribution thereafter is likely the tax optimal strategy for investing in an exchange fund.

Conclusion

There are many strategies a crypto investor can currently employ to monetize their positions, generate yield or diversify their positions. Each approach raises significant business and tax complexities that must be carefully evaluated in light of an investor’s individual circumstances. As the regulatory and tax landscape continues to evolve, thoughtful structuring—guided by experienced advisors—will be critical to optimizing outcomes and minimizing unintended consequences.

Aman Badyal is a Partner at Glaser Weil Fink Howard Jordan & Shapiro LLP. He has provided tax advice to various investors, investment fund managers and businesses operating in blockchain-related industries, including providing tax advice in connection with the formation of crypto investment funds, tax-deferred monetization of Bitcoin, the formation and classification of decentralized autonomous organizations (DAOs), initial coin offerings (ICOs), and the purchase or issuance of Simple Agreements for Future Tokens (SAFTs).

[i] See General Counsel Memoranda 36948.

[ii] See Cottage Savings Association v. Commissioner, 499 U.S. 554 (1991), and Treasury Regulations Section 1.1001-1(a).

[iii] Revenue Ruling 2023-14.

[iv] See Treasury Regulations Section 301.7701-1(a) (A joint venture or other contractual arrangement may create a separate entity for federal tax purposes if the participants carry on a trade, business, financial operation, or venture and divide the profits therefrom.)

[v] See Internal Revenue Code (“Code”) Section 721. While Code Section 721(b) does tax certain contributions of stocks or securities to investment partnerships, neither BTC nor ETH should be subject to Code Section 721(b) under current law.

[vi] See Code Section 704(c).

[vii] See Code Section 737.

[viii] See Code Section 731. While Code Section 731(c) does tax certain partnership distributions of marketable securities, under current law, neither BTC nor ETH should be subject to Code Section 731(c).