DeFi Is The Future! A Guide To Understanding Tax Implications of DeFi and Yield Farming

Tax Implications of DeFi and Yield Farming

Crypto Taxes: The Basics

It is important to know that pursuant to guidance issued by the IRS (Notice 2014–21), the IRS treats cryptocurrencies (they use the term “virtual currencies”) like Bitcoin, Ethereum, AAVE and UNI as property for tax purposes.

This means that crypto transactions in which you sell crypto for fiat currency, trade BTC for ALTs or ALTs for BTC, or use crypto to buy goods or services will trigger a taxable event. These transactions will result in either a capital gain or a capital loss, depending on whether your crypto investment appreciated or depreciated prior to the taxable event.

In addition to capital activity, crypto transactions in the form of mining, staking, airdrops, or earned interest will result in ordinary income and will be taxed at ordinary income tax rates (meaning no potential benefit of long-term capital gain).

DeFi Taxes: It’s Complicated

Decentralized finance (DeFi) is a rapidly growing area of cryptocurrency in which public blockchains are creating financial services without the need of centralized intermediaries. In short, this allows users to trade, lend and borrow without the fees, restrictions and hold-ups that come along with banks and financial institutions.  

With the advent of DeFi, the financial system is being transformed before our eyes into an open-source system, granting transparent access to capital to individuals around the world with fewer hurdles to jump through (aside from the learning curve).

While the activity is decentralized, there are still tax implications that need to be taken into consideration when dealing with trading, lending, borrowing and yield farming. The purpose of this guide is to provide an understanding of how your DeFi transactions impact you from a tax perspective.

DeFi Taxes: Lending

DeFi protocols allow users to lend out their assets or contribute to liquidity pools. This activity results in a return or a “yield” to the user, which means that the return on the lending will result in taxable income. The tax treatment of the return depends on the underlying activity. The activity will either result in ordinary income or capital gains.

Ordinary Income Treatment – Earning Interest:

Interest that is earned from straight-up lending activity will be recognized as ordinary income and will be taxed at your ordinary income tax rates. For example, you may lend a token and for doing so, you earn more of that token (the interest) directly to your wallet. This type of interest income is similar to what we see with traditional financial institutions and the amount of income that is recognized is simply the fair market value of the token at the time of receipt.

Capital Gain Treatment – Liquidity Pool Tokens:

Recently, DeFi platforms are not in fact paying interest directly to a user’s wallet, but rather they are issuing Liquidity Pool Tokens (LPTs). A liquidity pool is essentially a pool of tokens that are locked in a smart contract to help facilitate efficient trading. The liquidity pool is basically an automated market maker, and the pools’ supply of liquidity helps prevent large fluctuations in pricing of an asset.

LPTs represent a user’s stake in the pool that they are providing liquidity to. The owner of the LPT is not actually being paid interest like in the ordinary income example above, but rather the value of their LPT is increasing as the liquidity pool is earning interest. When the LPT is eventually swapped back for the crypto asset, a capital gain will be triggered which will be equivalent in value to the appreciation in value of the LPT.

Overall Example:

Suppose Satoshi buys 1 ETH for $500. Over one year later Satoshi decides to test out the DeFi waters when the fair market value of 1 ETH is $1,000. Satoshi uses his 1 ETH to mint 1 aETH on AAVE. Satoshi will have a capital gain of $500 at this point in time when he swaps his 1 ETH for 1 aETH as Satoshi has seen a net accession to wealth. Satoshi was holding his 1 ETH for over one year, so this capital gain will receive favorable long-term capital gain rates.

Now, Satoshi decides to lend his 1 aETH and starts to earn interest. In the month of February, Satoshi earns .05 aETH of interest, which is worth $37.5 at the time of receipt. Satoshi will now have to recognize ordinary income in the amount of $37.5. So far, Satoshi has a long-term capital gain of $500 and ordinary income of $37.5. (Note: if Satoshi held the ETH for less than a year, Satoshi would have had a short-term capital gain, which means Satoshi would effectively have $537.5 of ordinary income for the year).

Finally, a few months later, Satoshi swaps his 1 aETH for 1 ETH. When this transaction takes place, 1 aETH is worth $800. Satoshi would now have $200 capital loss because his basis in the aETH was $1,000. Satoshi can use this capital loss to offset some of the $500 of capital gain they had in regards to the ETH to aETH swap.

DeFi Taxes: Borrowing

An individual can borrow in USD or in crypto by collateralizing their underlying crypto assets. You will always have to put up more in collateral than the value of the underlying loan in order to be approved for the loan. This type of activity does not trigger any tax as this is not a taxable event. In addition, this allows taxpayers to keep the holding period of the underlying asset intact, which can facilitate long-term capital gains by holding the asset for more than one year.

The reason why there is no taxable event is because the money that is being loaned will become due at some point, so the taxpayer has not technically been placed in a better economic position.

However, there are some activities in relation to a crypto loan that may trigger a taxable event. For example, if the price of the underlying crypto asset dramatically decreases, the lending platform where the loan was taken out may be forced to liquidate your collateral. This forced sale would be taxable and any gains from the sale would result in long-term or short-term capital gain, depending on the holding period of the underlying collateral.

DeFi Taxes: Interest Expense

In order to determine whether interest that is paid on a DeFi loan is deductible, we have to look at what the purpose of the loan was.

If the purpose of the loan was to deploy capital for personal use, the interest expense that goes along with the loan will not be deductible.

If the purpose of the loan was for investment, it is possible that the interest expense can be deducted as investment interest expense if an individual’s itemized deduction totals are larger than the standard deduction that they would receive. These expenses would be reflected on Schedule A of your tax return.

If an entity takes out a crypto loan and uses the funds for commercial purposes, the interest that is paid by the entity will be treated as an ordinary and necessary business expense and will be tax-deductible.

It is important to note, that the IRS has not yet issued specific guidance regarding the treatment of interest expenses related to crypto loans, so in order to determine the tax treatment, tax professionals must leverage their knowledge of traditional lending principles and apply it to the digital asset space to infer the tax implications.

DeFi Taxes: Earning Governance Tokens

A governance token is a token that allows the holder of the token to help make decisions about the future of the protocol that issued the token. These holders have the ability to make proposals and even change the system of governance of the protocol entirely.

Many DeFi protocols like Compound, Synthetix, Aave, MakerDAO and MStable distribute governance tokens. These tokens are taxable upon receipt. The taxable income equates to the fair market value of the token at the time of receipt. The distribution of these tokens will cause an individual to be taxed at their ordinary income tax rate.

After the governance token is received, an individual may want to sell the token on the market for a different crypto asset, or may want to sell for USD or a stable token. This subsequent sale would result in either a capital gain or loss, which will be short-term or long-term depending on the holding period of the underlying governance token.

DeFi Taxes: Yield Farming

Yield farming is also referred to as liquidity mining. Yield farming provides a method to generate rewards or a “yield” leveraging crypto assets. A yield farmer is effectively locking up their digital assets to earn a return on the underlying crypto asset. Yield farmers will search for the highest yield across numerous protocols in an effort to increase their return or their “yield”. Yield farmers have the ability to “stack” their yields and earn an even higher rate of return. Typically, yield farmers will use a DeFi application to earn a yield in the DeFi projects' token, but there are many different means to obtain a “yield”.

From a tax perspective, when a yield farmer is distributed tokens and has received their reward, the tokens are taxed as ordinary income based on the fair market value at the time of receipt. When the subsequent disposition of the asset occurs, the yield farmer now has capital activity and will have either a capital gain or loss, depending on whether the token appreciated or depreciated from the time of receipt.

DeFi Taxes: Gas Fees

Gas refers to the fee that is required to successfully conduct a transaction or execute a contract on the Ethereum blockchain platform. The gas fees are usually priced in small fractions of ETH, referred to as gwei.

Gas fees can be used to reduce the total proceeds received when executing a swap. Gas fees can also be used to add to your cost basis by the total USD value that was spent to facilitate the underlying transaction. 

Frequently Asked Questions:

What is DeFi?

Decentralized finance (DeFi) is a rapidly growing area of cryptocurrency in which public blockchains are creating financial services without the need of centralized intermediaries. In short, this allows users to trade, lend and borrow without the fees, restrictions and hold-ups that come along with banks and financial institutions. 

What is Liquidity?

Liquidity refers to an assets ability to be converted from the underlying asset to cash. Liquidity in crypto provides that there is no significant discount or premium when a buy or sell of a digital asset is attempting to be executed. Thus, liquidity in a market refers to the ability of the market to have assets purchased and sold at stable and transparent prices.

How is Decentralized Finance (DeFi) activity reconciled and reported?

In order to properly reconcile DeFi activity, a tax professional would need the ETH wallet addresses associated with the activity. The professional would then be able to trace all of the activity, report all interest income, establish basis in the underlying tokens, and determine capital gain and loss activity from the subsequent dispositions of the underlying tokens.

What is Yield Farming?

Yield farmers are rewarded for providing liquidity and other value to a protocol. Yield farmers are paid in proportion to the liquidity that they are providing and are reward with a “yield” for providing the liquidity. The “yield” generated incentivized users to provide liquidity.