The DeFi space that exists within the larger crypto industry has seen explosive growth in 2020. Fueled by yield farmers and crypto holders seeking opportunities to put their crypto to work, billions of dollars of cryptocurrency have been poured into DeFi and the Ethereum ecosystem at large.
With this flurry of new crypto activity comes the fated question: What are the tax implications for DeFi? How do DeFi transactions work from a tax perspective?
In this article, we dive into these questions and share the fundamentals of DeFi taxes as they relate to lending, borrowing, yield farming, liquidity pools, and earning.
In the U.S. and many other countries, cryptocurrencies are treated as property for tax purposes. Similar to other forms of property like stocks and bonds, you incur capital gains and capital losses when you sell, exchange, or otherwise dispose of your cryptocurrency. Capital gains and losses need to be reported on your taxes.
Additionally, when you earn cryptocurrencies through any means whether that is mining, staking, or forms of interest, you recognize income at the fair market value of the cryptocurrency at the time it is received. This income needs to be reported on your taxes.
While the IRS has not released any direct guidance on DeFi specifically, they have released general guidance on cryptocurrency. The tax implications for DeFi can be inferred from these guidelines. As more updates from a tax legislative perspective come out, this guide will be updated to reflect those changes.
If you are just starting to learn about the tax implications of crypto, we recommend starting out with our article: The Complete Guide To Cryptocurrency Taxes.
DeFi, short for decentralized finance, is an area of cryptocurrency focused on enabling access to financial services such as trading, lending, and borrowing without incurring the costs or delays associated with traditional rent-seeking middlemen (i.e. banks, financial institutions, etc).
The vast majority of popular DeFi platforms today are built within the Ethereum ecosystem. Some unique technological advancements such as Automated Market Making (AMM) and Liquidity Pools enable the “decentralized” capabilities of many of the most popular DeFi platforms today.
These new advancements create some unique tax situations which we address below.
When you lend your cryptocurrency out, you are liable to pay taxes on any income that you receive as a result of your lending activity.
The income that you receive as a result of your lending activity can take one of two forms. Depending on the DeFi platform you are using, your income will either be:
The distinction between capital gains income vs. ordinary income is an important one to understand because they carry different tax implications.
Ordinary income (like income from a salary) is simply taxed at your marginal tax bracket. Because of this, ordinary income doesn’t carry significant tax savings opportunities.
Capital gains income on the other hand does have significant tax savings benefits. The first benefit of capital gains income is the long-term capital gains tax rates, which you qualify for if you held your asset for longer than 12 months. Long term capital gains tax rates are significantly less than short term capital gains rates and can save you a lot of money in taxes owed if you strategically plan for them.
Additionally, capital gains income can be completely offset by capital losses—whereas capital losses cannot fully offset ordinary income (they can only offset up to $3,000 of ordinary income).
Let’s now take a look at ordinary income vs. capital gains as they apply within the DeFi space.
In the traditional world, and even in the centralized cryptocurrency space, lending platforms often pay out interest in the same currency that you lent them (like interest you receive from a bank or like crypto interest you receive from a crypto lending platform like BlockFi). For example, if you lent ETH, the interest payments that you earn from a deposit would often also be in ETH.
When this is the case, the interest that you are earning qualifies as ordinary income.
In other words, if you earn crypto tokens for lending (e.g. your wallet balance directly increases when you earn the interest income), then you recognize this as ordinary income.
Many new DeFi protocols issue Liquidity Pool Tokens (LPTs) when you lend them your crypto. These LPTs represent the portion of your stake in the liquidity pool.
In this case, you may recognize capital gains income, not ordinary income, from interacting with the protocol.
This is because adding your tokens to a liquidity pool and receiving LPTs is actually structured as a trade/token swap.
As the liquidity pool accrues interest, the value of your stake in the pool increases—such as with cTokens. However, you aren’t actually paid out this interest directly (like you were in the ordinary income example). Rather, the value of your LPTs (cTokens) increases as interest accrues while the amount of LPTs you own stays constant. When you swap your LPTs back for the underlying asset, you trigger a capital gain equal to the amount that the LPTs have accrued in value, and this is treated as capital gains income.
DeFi platforms such as Compound and yearn.Finance and their associated cTokens and yTokens are good examples of protocols in which the “interest accruing” actually gets treated as capital gains because transactions are structured as token swaps/trades.
On the other hand, on platforms such as Aave the interest accrued from lending gets paid out to you directly in the form of aTokens and is thus treated as ordinary income, not capital gains.
As Compound states on its website: “As a market earns interest, its cToken becomes convertible into an increasing quantity of the underlying asset.” Put another way, as the crypto you lent into Compound earns interest, your cTokens (which represent your stake in the pool) become convertible for an increased quantity of the underlying asset (i.e. the crypto you lent into Compound).
This means that you aren’t actually earning disbursements of interest rewards from Compound directly. From a tax perspective, this means that the income associated with your cTokens is capital gains income (not ordinary income) recognized when you convert your cTokens back to the underlying asset.
Contrary to cTokens, aTokens are minted at a 1:1 ratio to the underlying asset. This means that you are paid out in aTokens as the cryptocurrency that you lent earns interest. These aToken interest payments are treated as ordinary income equal to the fair market value of the aToken at the time it is received.
We’ve covered a lot of ground so far, so let’s stop to look at a full example of the step-by-step tax treatment for a common interaction with a DeFi protocol like Aave.
In summary, Lucas first recognized a $100 capital gain, then $30 of ordinary income, and then a $100 capital loss. Because Lucas’s capital loss would fully deduct from his capital gain, he would only owe taxes on his $30 of ordinary income in this example.
As you can see, it’s easy for things to get complicated very quickly from a tax reporting perspective. This is where cryptocurrency tax software can be beneficial for automating all of your income tax reporting.
Advancements in the way decentralized exchanges enable crypto-to-crypto trading (via automated market making and liquidity pools) has brought on a wave of new cryptocurrency activity focused on earning yield. “Yield Farmers” or “Liquidity Miners” seek to earn rewards by using their crypto holdings as collateral to earn yield/interest.
The tax implications of this activity is no different than the examples walked through above.
The interest rewards received from loaning out your cryptocurrency are subject to income tax, and depending on the specifics of the protocol, they will either be capital gains income or ordinary income (see section above).
Governance tokens used to incentivize cryptocurrency holders to use their assets as collateral to fund liquidity pools have become common and have allowed “Yield Farmers” to ramp up their potential earnings.
Popularized by Compound’s COMP governance token, COMP is distributed to anyone who supplies or borrows crypto to/from Compound.
You recognize income when you receive governance and incentive tokens similar to COMP. The amount of income you recognize is equal to the market value of COMP (or whatever the governance token) at the time it is received.
Additionally, when you sell your COMP (or related governance token), you trigger a taxable event and recognize a capital gain or capital loss depending on COMP’s fluctuation in value since you earned it.
So far we have focused on the tax implications for one side of the market, the lender. But what if you are the borrower? What are the tax implications of taking out a loan?
If you take out a loan using cryptocurrency as collateral, you do not trigger a taxable event. This is different from “trading” your crypto for another crypto, and it has tax advantages due to this fact.
John takes out a stablecoin loan on his ETH holdings. John receives 1,000 DAI as a loan based on his ETH he put up as collateral. John does not trigger any tax event when borrowing 1,000 DAI.
The IRS has yet to issue specific guidance surrounding interest payments in crypto lending. However, you can get a better idea for how they may be treated by looking at traditional lending. To understand whether your interest payments are tax-deductible, it is necessary to consider whether a loan is used for personal, investment, or business-related purposes.
If a business takes out a loan for a commercial purpose, the interest is treated as a legitimate tax-deductible business expense.
If a loan is taken out for personal reasons, interest expense is usually not considered tax-deductible.
If you use the borrowed funds for investment purposes (yield farming for example) the interest expense you incur is classified as investment interest expense. Investment interest expenses are subject to special tax rules and are deductible only up to your net investment income.
Below we have summarized the high level tax implications relating to specific DeFi protocols. Keep in mind, the IRS has not passed any specific DeFi tax guidance to date. The below descriptions represent conservative tax treatment inferred from the current IRS crypto guidelines.
Uniswap is a decentralized exchange that allows users to trade/swap between cryptocurrencies as well as contribute crypto to liquidity pools to earn income.
Compound is a decentralized protocol that enables borrowing, lending, and the earning of interest.
Aave is a DeFi protocol that allows users to provide liquidity, earn interest, and borrow funds.
Maker and their Oasis platform allow users to trade between assets as well as earn DAI either by locking ETH or other cryptocurrencies as collateral or via DAI savings.
Similar to Uniswap, Balancer allows you to trade or swap cryptocurrencies as well as contribute to liquidity pools.
Disclaimer - This post is for informational purposes only and should not be construed as tax or investment advice. Please speak to your own tax expert, CPA or tax attorney on how you should treat taxation of digital currencies.