By Eric Smith 
Wrapped tokens are a foundational part of modern crypto transactions. They allow you to move your assets across blockchains and get involved in DeFi. From our crypto accounting standpoint, wrapped tokens introduce a level of complexity that is often overlooked, particularly when determining whether wrapping or unwrapping a token constitutes a taxable event. In this post, the team at Onchain Accounting will help clear all your doubts by explaining how wrapped tokens work, when it may be considered a taxable event, and what investors need to do to stay compliant with their obligations.
A wrapped token is a digital asset in one blockchain that mirrors the value of another digital asset in a separate blockchain. Since each blockchain operates independently and under its own rules, wrapped tokens are used to enhance interoperability between blockchains, allowing us to use assets in one blockchain in another.
We create a wrapped token by first securing the original asset in a digital vault. Once the asset has been secured, new tokens will be minted in a different blockchain that matches the value.
For instance, consider Bitcoin (BTC) and Ethereum (ETH), the two most popular cryptocurrencies. As a BTC holder, if you want to conduct transactions in the ETH blockchain, you must first lock your BTC in a secure vault. Once you have done that, you will be issued a wrapped BTC (WBTC), which you can use to carry out transactions in the ETH blockchain.
If you want to take a look at an equivalent everyday example, imagine a situation where you hand your coat at an event. Your coat is the original item, which you give to the event staff for safekeeping. To prove that the court belongs to you, the staff issues you a ticket. From crypto speak, the ticket is your wrapped token. While the coat is secured, the ticket allows you to move freely and later reclaim your coat once the event is done.
Wrapped tokens are a relatively new phenomenon, and most jurisdictions have not introduced clear guidelines on whether they constitute taxable events. That being the case, it has resulted in a conservative and aggressive viewpoint.
In the conservative approach, wrapped tokens are treated as crypto swaps, which are taxable events in most jurisdictions. On the other hand, the aggressive viewpoint emphasizes that wrapping the token is merely holding the same asset in a different way. Since it is the same asset, there is no disposal of assets, and it does not become a taxable event.
However, in the US, the Inland Revenue Service (IRS) treats wrapped tokens as taxable events. When the crypto-to-crypto swap increases in value under fair market conditions from the original cost basis, then the transaction will be subject to capital gains tax.
Wrapped tokens are a new phenomenon in crypto that has made transactions between blockchains a lot easier. But it is also something that blurs the line between simple transfers and taxable events. That is why when you wrap tokens, you will need the knowledge and expertise of a skilled cryptocurrency accountant to see the job done right.
At Onchain Accounting, our cryptocurrency accountants specialize in reviewing transactions and bridging blockchains. We go above and beyond to make sure that all your crypto activities are reported correctly and comply with rules and regulations. Wrap, unwrap, and trade with confidence because Onchain Accounting has your back.