The Essential DeFi Tax Guide

Everything you need to know about DeFi taxes, all in one place. Learn about taxes on crypto interest, staking, wrapped tokens, and more.

Zac McClure
ByZac McClure, MBA Expert reviewed byArthur Teller, CPAUpdated on September 20, 2022 · minute read

TokenTax content follows strict guidelines for editorial accuracy and integrity.

Key Takeaways

  • Basic guidance about crypto taxes apply to DeFi transactions: earnings from disposing of a held asset are capital gains, while crypto paid directly is taxed as income.

  • However, the complexity of DeFi mechanisms creates gray areas in tax treatment. Transactions about which there is uncertainty include wrapping tokens, minting interest bearing tokens, transfers into and out of liquidity pools, and multichain bridging.

The Essential DeFi Tax Guide

Decentralized finance (DeFi) is a rapidly growing crypto segment that increases people’s access to financial services—including trading, borrowing, and lending—without the delays and fees typically associated with traditional financial intermediaries.

However, the mechanisms of DeFi protocols often create confusing tax situations, a challenge that is compounded by the IRS’ lack of guidance on the subject.

How is DeFi taxed?

The basic existing IRS guidance about DeFi taxes is:

When you earn crypto from an asset appreciating in value, you pay taxes on capital gains.

Example: Crypto capital gains transaction

Capital gains corrected

Examples of crypto taxable events include:

  • Selling crypto for fiat

  • Trading a token for a different token

  • Using crypto to buy goods or services

When you earn crypto directly, it is taxed as ordinary income.

Example: Crypto income transaction

Ordinary income

Examples of crypto income events include:

Read on for more in our comprehensive guide to taxes on DeFi transactions.

DeFi taxes on lending

Depositing collateral for a loan: Not taxable

It is not a taxable event to use crypto as collateral for a loan as long as you do not receive a different token in return. As long as your collateral is not sold or exchanged, no tax liability will be triggered.

Forced liquidations: Capital gains

If a cryptocurrency’s value decreases enough that a platform cannot maintain borrowers’ loan-to-value ratio, the platform will issue margin calls, which require borrowers to put up additional collateral.

If a margin call is not met, a platform may force a liquidation of the borrower’s collateral. In this scenario, the borrower will owe capital gains taxes on the forced liquidation, even though they will not receive the profits.

Receiving collateral back as a different coin: Possibly taxable

Putting crypto up for collateral is normally not taxable. However, if you choose to receive your collateral back as a different coin than the one you deposited, this may be a taxable event.

For example, if you put up ETH as collateral, but receive DAI back when you close out your loan, you may owe capital gains taxes since there was an exchange of ETH for DAI.

Self-repaying loans: Debt cancellation income

The Alchemix protocol offers “self-replaying loans,” in which the user essentially deposits collateral, borrows capital, and the internals of the protocol earn yield with the collateral to repay your loan over time. This loan structure does trigger income tax liability by creating what is called “debt cancellation income.”

Alchemix debt cancellation income example

  • A user deposits 10,000 DAI of collateral to the Alchemix protocol in exchange for a loan of 15,000 alUSD.

  • The protocol deposits the 10,000 DAI into a liquidity pool, which mints 500 DAI for the protocol over the course of a tax year.

  • The protocol subtracts that 500 DAI from the user’s debt, resulting in 500 DAI of debt cancellation income for the user.

DeFi staking and interest taxes

Crypto interest and staking earnings can be taxed as either capital gains or income. This is because interest and staking income can be distributed in two ways: as additional tokens or as an increase in the value of existing tokens.

Assets earned as additional tokens: Ordinary income

Some DeFi platforms distribute interest or rewards by depositing additional coins into a lender’s wallet. This is taxed as ordinary income, like from a salary or direct payment for a good or service. AAVE’s aTokens work like this.

aTokens ordinary income example

  • You loan 10,000 DAI on AAVE.

  • In exchange, you receive aDAI that represents your deposit.

  • As you earn interest, you will earn additional aDAI, so that your wallet balance grow.

  • After a year, you’ve earned 300 DAI and remove your funds. You would owe crypto income taxes on that $300.

Earnings from tokens that increase in value: Capital gains

Some DeFi platforms (Yearn, Compound) distribute interest not as additional tokens, but as an increase in the value of a lender’s interest-bearing tokens. These proceeds are taxed as capital gains. That is because the number of tokens in the lender’s wallet does not increase; rather, the existing tokens increase in value.

cTokens capital gains example

  • You supply 20,000 DAI to Compound.

  • In exchange, you receive cDAI that represents your share of the supply.

  • As you earn, rather than earn additional cDAI tokens, your existing cDAI increases in value.

  • After a year, your cDAI is worth 20,500 DAI. You remove your funds from the supply, and will owe crypto tax on $500 worth of capital gains.

DeFi taxes on governance tokens

Governance tokens represent a holder's stake in a protocol. They often come with certain powers, such as weighted votes in protocol governance issues. Holders of governance tokens may also receive a portion of the network's fees.

Receiving governance tokens: Ordinary income

Many DeFi platforms distribute governance tokens as incentives for activity. Strategically pursuing these offers is commonly known as yield farming. Crypto rewards are typically taxed as ordinary income.

Governance token income example

  • You receive $500 worth of SPELL in exchange for your activity in Abracadabra.

  • You owe DeFi taxes on that $500 of ordinary income.

Trading governance tokens: Capital gains

When you sell or trade governance tokens that have increased in market value since you received them, you owe capital gains tax.

Governance token capital gains and losses examples

  • If you earn 10,000 SPELL when SPELL is $.02, you owe income tax on that $200.

  • If you sell that 10,000 SPELL when it reaches $.04, you will then owe capital gains taxes on your $200 of income.

  • However, if you sell the 10,000 SPELL at $.01, you’ll have a capital loss of $100. Note that this does not directly offset the SPELL ordinary income.

DeFi tax gray areas 

The IRS hasn’t issued guidance on any of the situations discussed below. Overall the safest way to treat these transactions is as crypto-to-crypto exchanges that result in capital gains or losses. However, depending on your CPA's guidance, you can treat minting interest-bearing tokens as non-taxable. In TokenTax, you can do this by changing the transaction's type to "migration" instead of "trade" on your All Transactions page.

Wrapped tokens

A wrapped token is one whose value is pegged to another coin. Users commonly wrap tokens so they can be used cross chain.

Examples of such transactions include:

  • If you make ETH an ERC-20 token, you create wETH

  • If you wrap stETH, you create wstETH

The tax implications of wrapping tokens are not clear. The IRS has not issued any specific guidance on these topics, so while some crypto CPAs may choose to interpret these as taxable, others may not.

Minting interest-bearing tokens

The most relevant IRS guidance states that crypto-to-crypto exchanges are taxable events that result in the realization of a capital gain or loss. So, the question at hand is: is minting an interest-bearing token a crypto-to-crypto exchange?

The answer? We're not sure and have to wait for guidance from the IRS

The following scenario illustrates the challenge of determining the correct tax treatment:

You deposit ETH into Lido. In return, you receive stETH, which accrues staking rewards. stETH represents your staking share, but it is also a liquid staking solution.

This means that you can sell your stETH on an exchange or use it to “double dip” to earn extra yield. Here is the grey area: is the stETH you receive simply a receipt of your deposit? Or is ETH->stETH a token-to-token exchange and thus a taxable event?

Liquidity pool transfers

When you deposit funds into a liquidity pool, in return you receive an LP token that represents your share of the pool. This is similar to minting a coin to represent funds deposited to a protocol for crypto lending or staking.

One position is that this exchange is merely a deposit, with the LP token representing your original deposit ratio. In this interpretation, depositing or withdrawing your funds from a liquidity pool would not be a taxable event. This is a more aggressive stance

A more conservative position is that these actions are taxable events because they are crypto-to-crypto trades; the crypto you deposit is exchanged for an LP token. Proponents of this position point out that, because of changing token rations, when leaving a pool, aa liquidity pool supplier’s financial situation is rarely the same as it was when they entered. If a lender's economic situation has changed, they have likely realized a taxable event.

Taxes on multichain bridging

Conceptually the bridging is similar to wrapping or minting a token. For example, Interlay allows users to mint bitcoin onto Polkadot as PolkaBTC. Thus, like minting or wrapping tokens, bridging crypto could likely be interpreted as either a taxable or non-taxable event.

Taxes on DeFi rebasing tokens

To maintain a consistent token value, a protocol with a rebasing function periodically adjusts the total coin supply according to the token’s price fluctuations. In other words, if the target value for a coin is $1, but the price drops below that, the protocol will reduce the number of coins in circulation. The opposite will occur if the price climbs above $1.

There are several potential treatments that have been discussed in the crypto tax community. The most aggressive would be to view rebasing as a corollary to stock splits.

In traditional markets, a stock split occurs when a company divides its existing shares in order to increase liquidity.[1] This is not considered a taxable event because although a shareholder now owns more shares, those shares have the same market value as the shares he or she held before the stock split. A taxable event would only occur when and if the investor sold their shares for more than they were worth at the time they were received.

If we applied this treatment to rebasing tokens, capital gains would be only realized when and if you sell your asset for more than it was worth when it was deposited in your wallet.

Additional conservative approaches would be considering rebase income as dividend payments in kind or as regular income.

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References

Last reviewed by Arthur Teller, CPA on September 20, 2022 · Sources

Zac McClure
Zac McClureCo-Founder at TokenTax
Zac co-founded TokenTax after his career in international finance and accounting at JPMorgan, Imprint Capital and Bain. He has worked in more than half-dozen countries and received his MBA from the UPenn Wharton School.
Arthur Teller
Reviewed byArthur TellerCOO at TokenTax
Arthur came to TokenTax after 12 years at KPMG. A specialist in partnership taxation and enterprise tax software, he is a licensed CPA in both California and Illinois and a member of the AICPA.

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