Bitcoin has the crypto market’s largest market capitalization at around $250 billion, according to CoinMarketCap, along with more trading volume than most other cryptocurrencies. While Bitcoin is undoubtedly the best-known cryptocurrency in the world, there have been a growing number of opportunities for traders and investors to consider in the space.
These opportunities are increasingly encroaching on the conventional financial sector, enabling investors to earn interest from loans and purchase equity in companies. As the crypto market continues to mature, investors may want to keep a close eye on these opportunities, particularly given the attractive yields compared to conventional assets.
Let’s take a look at three up-and-coming crypto investments for your portfolio, as well as their tax implications.
Decentralized Finance, or DeFi, is an ecosystem of applications built on smart contracts that provide an alternative to conventional financial services. For example, peer-to-peer crypto lending platforms provide low-friction loans between crypto users, enabling borrowers to access low-cost loans and lenders to generate attractive yields.
Here’s how it works: An investor deposits crypto into a DeFi smart contract that automatically loans the crypto assets to a borrower that pays interest. The smart contract dynamically manages interest rates based on the real-time supply and demand for loans, which ensures a perfect market equilibrium for both borrowers and lenders.
Coinbase’s Lending Capabilities - Source: Coinbase
There are many different DeFi protocols, such as Compound and Uniswap, that power an even larger universe of applications. Coinbase is perhaps the best-known crypto wallet that provides access to DeFi apps, enabling users to earn up to a 6% APR on their crypto assets. Of course, smart contracts are subject to the same risks as any other computer program—so be careful!
Initial Coin Offerings
Initial coin offerings, or ICOs, have become a popular method to fund startups that aim to offer products and services in the crypto space. Rather than selling a stake in the business, these startups sell utility tokens that will ultimately be used in their product or service. The assumption is that these tokens will go up in value if the business is successful.
Early ICOs were characterized by pyramid schemes and other scams where investors would purchase coins with little more than a shiny website. Not surprisingly, the SEC quickly stepped in and began cracking down on these unregulated offerings to protect investors. These interventions mean that most ICOs are now off-limits to U.S. investors.
The evolution of ICOs and DeFi has naturally led the industry to pursue tokenized securities as a way for startups to raise capital in a decentralized fashion. Unlike ICOs, tokenized securities would provide an ownership stake in a company (similar to a stock) or a share in the company’s revenue, making it a security rather than a part of a business.
In August 2020, INX Limited was approved by the SEC to launch a public offering of crypto tokens under a Reg A+ exemption, providing investors with an opportunity for profit-sharing. While INX acknowledges that there isn’t a public market for its tokenized securities yet, the company plans to build an exchange for token securities to trade.
The Reg A+ exemption for crowdfunded businesses and INX’s success in launching a public offering suggests that tokenized securities could become more common in the future. In fact, Overstock.com Inc.’s tZERO aims to power digital securities by facilitating tokenizations for securities and providing an easy way to trade those tokens.
The IRS treats all cryptocurrencies as property that is subject to capital gains tax. While accounting for a few investments is relatively straightforward, the tax preparation process becomes a lot more complex and time-consuming if you have a large volume of trades or participate in unusual or complex investments (such as DeFi, ICOs or investment tokens).
ZenLedger can help simplify tax preparation by aggregating transactions across wallets and exchanges, computing capital gains or losses and auto-filling popular IRS forms, including Form 1040 Schedule D and Form 8949. A defensible audit trail ensures that you’re protected in the event of an IRS audit and never overpay taxes.
ZenLedger’s Tax Preparation Platform - Source: ZenLedger
In addition to preparing taxes, ZenLedger’s tax loss harvesting tool makes it easy to identify opportunities to offset tax liabilities. The unique nature of crypto securities means that investors can realize losses and replace securities in their portfolio without running afoul of the Wash Sale Rule that prohibits similar behavior in stocks.
The Bottom Line
Bitcoin, Ethereum and Litecoin may be some of the best-known cryptocurrencies in the market, but a new generation of investment opportunities is quickly rising. DeFi, ICOs and tokenized securities promise to transform the financial services sector and enable investors to access new opportunities that haven’t been possible until now.
Investors may want to consider diversifying their exposure to crypto assets with some of these opportunities. For instance, long-term holders may want to lend crypto assets to generate interest on their holdings and compound their returns over time. That said, investors should carefully assess each opportunity and ensure they diversify risks.
Of course, investors should ensure that they properly account for these opportunities when doing their taxes each year. ZenLedger can help simplify tax season by aggregating transactions and computing capital gains and losses, as well as help you save money through tax loss harvesting throughout the year.