Navigating DeFi: Opportunities and Tax Challenges

Decentralized finance (DeFi) allows crypto users to trade, borrow, and lend without the need for traditional banks or intermediaries. This creates unique challenges when it comes to tracking and reporting taxes.

The IRS has issued general guidelines on how to handle crypto taxes, but they haven’t fully addressed DeFi activities. Without clear rules, DeFi users need to be cautious and may want to seek professional crypto tax advice to avoid penalties.

International taxpayers can refer to our helpful country guides for more information about DeFi taxes outside the US.

The IRS treats cryptocurrencies used in DeFi transactions as property. Every time you trade, earn, or sell in DeFi, it could be a taxable event.

There aren’t yet specific DeFi tax rules, but general crypto tax rules apply. In short, it’s essential to keep detailed records of all transactions and seek help from crypto tax experts when in doubt.

Learn more about the current tax rates for cryptocurrency.

Depending on your DeFi activities, you may need to file the following IRS forms:

• Form 8949: Reports sales and exchanges of crypto, including DeFi trades.

• Schedule D (Form 1040): Summarizes capital gains and losses.

• Schedule 1 (Form 1040): Reports additional income, like staking rewards.

• Form 1040: Asks if you have dealt with cryptocurrency.

• Form 1099-MISC: Reports miscellaneous income such as DeFi lending interest.

Failing to report transactions properly could lead to penalties or audits.

The IRS generally taxes DeFi earnings in two main ways:

• Capital assets: If you trade or sell crypto, it’s treated as a capital asset like stocks in traditional finance. Any profit you make from selling or exchanging your tokens is subject to capital gains tax.

• Income: Income from staking or yield farming is taxed as ordinary income. The value of the crypto when you receive it determines how much tax you owe.

Learn more about Ethereum staking.

The IRS separates DeFi taxes into two categories:

• Capital gains: This applies to buying, selling, or trading crypto. Any profit is subject to capital gains tax.

• Ordinary income: Income from staking, liquidity mining, or yield farming is taxed when you receive it.

DeFi users should expect to pay ordinary income or capital gains taxes on crypto transactions. Here’s a brief overview of how the IRS handles DeFi taxes.

DeFi activities have different tax implications, and understanding each is important. Here are some common scenarios:

• Lending and borrowing: Using crypto as collateral for a DeFi loan isn’t taxed, but any interest you earn is taxable as income. Read more about crypto loans.

• Liquidity mining: Providing liquidity in exchange for rewards is taxed as income. The tax amount depends on the market value of the rewards when you receive them.

• Staking: Staking rewards are treated as ordinary income and taxed based on their value at the time of receipt. Learn more about crypto staking taxes.

• Trading and token swaps: Swapping one cryptocurrency for another is typically taxable. You’ll need to calculate the gain or loss by comparing the old token's acquisition cost to the new one's value.

• Yield farming: Like staking, yield farming rewards are taxed as income when you receive them.

Learn more about crypto interest tax.

Consider the following options to lower your taxes on DeFi activities.

• Hold long-term: Holding crypto for over a year means any profit qualifies for a lower long-term capital gains tax rate.

• Use tax-loss harvesting: Sell underperforming assets to offset your gains from better investments.

• Keep good records: Proper documentation is crucial for reducing taxes and taking advantage of deductions.

• Use crypto tax software: Tools like ours at TokenTax can help you track your transactions and optimize your tax strategy.

DeFi transactions can be complex, so following these best practices will help you stay compliant.

• Keep complete records: Document every transaction, from trading to staking.

• Use tax software: TokenTax integrates with popular DeFi platforms to automatically pull transaction data and calculate taxes.

• Consult professionals: Given the complexity of DeFi taxes, working with

  crypto tax experts who understand crypto taxation can be a smart move, especially for active traders.

Governance tokens are often awarded to users who participate in a DeFi protocol, granting them voting rights or decision-making power within the platform. However, receiving these tokens can have tax implications.

• Receiving governance tokens: When governance tokens are distributed as rewards or incentives, they are treated as ordinary income. The taxable income is based on the fair market value of the tokens at the time they are received. These tokens should be reported as income on your tax return.

• Selling governance tokens: If you later sell or trade your governance tokens, the transaction is subject to capital gains tax. The taxable event occurs when you dispose of the token, and the gain or loss is determined by the difference between the token’s value at the time you received it and its value at the time of sale.

DeFi loans allow users to borrow crypto assets by using crypto as collateral. These loans operate much like traditional loans but have unique tax considerations.

• Taking out a DeFi loan: Generally, borrowing crypto is not taxable. You won’t owe taxes simply for taking out a loan, as you’re not disposing of any assets at this stage.

• Liquidation of collateral: If your collateral is liquidated to cover the loan, this is considered a taxable event. You would need to report any capital gains or losses from the sale of the collateral based on its value at the time of liquidation compared to when you initially received it.

• Interest payments: The IRS has yet to provide specific guidance on the tax treatment of interest payments for DeFi loans. However, interest paid on a loan used for business or investment purposes might be deductible, similar to traditional loans.

Learn more about crypto loans.

Bridging tokens allows users to transfer assets between blockchains, but this process may involve tax implications. Unlike wrapping, bridging tokens from one blockchain to another does not usually trigger a taxable event. This movement is often considered non-taxable since the assets aren’t being swapped but simply transferred across networks.

Some taxpayers take an especially cautious approach and treat bridging as a crypto-to-crypto exchange, reporting it as a taxable event. However, with clear IRS guidance, most experts treat bridging as a non-taxable event if other factors trigger a taxable event, like liquidating assets during the process.

Looking to calculate your crypto taxes? Try our free crypto tax calculator.

Wrapped tokens allow crypto holders to use their assets on different blockchains, like wrapping Bitcoin (BTC) to interact with Ethereum-based DeFi protocols. However, when it comes to taxation, wrapping tokens fall into a gray area, as the IRS has yet to provide specific guidance.

There are two common approaches to handling the taxation of wrapped tokens:

• Conservative approach: Some investors treat wrapping a token as a crypto-to-crypto exchange. This means you would recognize a capital gain or loss based on the token's market value at the time of wrapping. For instance, if you own BTC worth $1,000 and the value rises to $1,800 before wrapping it into WBTC, you would incur $800 of capital gains.

• Aggressive approach: Another approach is to treat wrapping as a non-taxable event, arguing that ownership of the underlying asset remains the same. In this case, the wrapping would not trigger any capital gains or losses.

Liquidity mining, where users provide assets to a liquidity pool in exchange for rewards, often has tax implications. When you deposit crypto into a liquidity pool and receive liquidity provider (LP) tokens in return, this may trigger a taxable event under current IRS crypto guidance.

Learn more about liquidity pool tax.

Depositing liquidity: Capital gains

When you deposit cryptocurrency into a liquidity pool, you effectively exchange one asset (your crypto) for another (LP tokens). This is commonly treated as a crypto-to-crypto trade, which means you may need to report any capital gains or losses. The gain or loss is based on the difference between the value of the crypto when you acquired it and its value at the time of the deposit.

Withdrawing liquidity: Capital gains tax

When you withdraw your assets from the liquidity pool, you will likely have to trade your LP tokens back to regain your original crypto. This is considered another crypto-to-crypto exchange, which could trigger additional capital gains or losses.

Conservative vs. aggressive tax approaches to liquidity mining taxes

Since the IRS has not issued specific guidance on liquidity mining, there are two common approaches to reporting these transactions:

• Conservative approach: Treat both the deposit and withdrawal of liquidity as crypto-to-crypto trades, recognizing capital gains or losses at each step. This method is more in line with existing IRS crypto rules and minimizes the risk of underreporting.

• Aggressive approach: Some investors argue that receiving LP tokens is similar to depositing at a bank, which is not taxable. In this case, they treat the exchange of crypto for LP tokens as non-taxable, asserting that ownership hasn't been transferred.

Learn more about what is DeFi?

Some users erroneously believe DeFi’s decentralized nature and lack of Know Your Customer (KYC) regulations provide an easy path for tax evasion. However, the transparency of blockchain technology makes it possible for authorities like the IRS to trace transactions, even without direct reporting from DeFi platforms.

The IRS has worked with blockchain analysis companies like Chainalysis to monitor blockchain activity and identify tax fraud. In addition, future regulations may increase reporting requirements for DeFi platforms. For example, starting in 2026, decentralized exchanges may be required to provide 1099-DA forms, including reports to the IRS.

While DeFi protocols do not currently report directly to the IRS, users should assume that their on-chain transactions are visible and traceable. Failing to report these activities accurately can result in severe penalties. To stay compliant, consider using tax software like TokenTax or consulting a tax professional to ensure all transactions are correctly accounted for.

Learn more about what is a DEX?

TokenTax specializes in DeFi tax reporting, making it easier to stay compliant. Our platform integrates with blockchains and DeFi platforms to automatically track transactions and calculate taxes. We also provide access to crypto tax experts for personalized advice.

DeFi tax FAQs

How can you profit from DeFi?

DeFi allows you to profit through lending, yield farming, and trading. However, each comes with tax obligations, so keeping accurate records is essential.

Do you pay taxes on DeFi investments?

Yes, profits from DeFi investments are subject to taxes. Depending on how long you held the asset, these gains may be taxed as short- or long-term capital gains.

Is DeFi interest taxable?

Yes, interest earned through DeFi platforms is taxable. It’s usually treated as ordinary income and should be reported on your tax return to remain compliant with IRS rules.

Is DeFi borrowing taxable?

No, taking out a DeFi loan is not taxable by itself. However, income generated from borrowed funds may be taxed, and the interest expense might be deductible if the loan is for business purposes.

How can individuals track and report DeFi transactions for tax purposes?

Using crypto tax software that connects to blockchain networks is the most efficient way to track DeFi transactions. Consulting a tax advisor specializing in cryptocurrency is also helpful for complex tax filings.

Are there tax implications for US taxpayers using DeFi platforms outside the US?

Yes, US taxpayers may need to report DeFi transactions on foreign platforms under FATCA or FBAR. If the DeFi platform is considered a non-U.S. entity, income from these activities could be taxed as ordinary income.

Can the IRS track DeFi wallets?

While DeFi transactions occur on decentralized platforms, they are traceable on public blockchains. The IRS can access transaction data through foreign firms under FATCA or when assets move to centralized U.S. exchanges.

Are transfers between personal DeFi wallets taxable?

No, moving crypto between your wallets is not a taxable event. These transfers are not sales, so your cost basis and holding period stay the same.

What are non-taxable DeFi transactions?

Borrowing against crypto isn’t usually taxed, but selling the collateral later can trigger capital gains. Remember that tax rules are evolving, and what’s non-taxable today might be taxed later.