The Essential DeFi Tax Guide for 2023
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The IRS has not provided specific guidance concerning DeFi tax but does provide direction concerning digital assets, which are treated as property and subject to the corresponding taxes. This includes DeFi.
Because of DeFi’s complexity and the numerous ways people use DeFi to make money, the tax implications are complex but can be understood by drilling into specific DeFi transaction examples and use cases as our experts have done in this comprehensive article.
What is DeFi?
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.
In DeFi, funds are created from liquidity pools, which anyone with collateral (or sometimes even without) can utilize these pools for a variety of purposes.
The IRS & DeFi tax
The complex mechanisms of DeFi protocols often create confusing tax situations, a challenge that is compounded by the IRS’ lack of guidance on the subject.
The IRS has provided guidance on digital assets as a whole, which we can refer to in order to understand DeFi tax implications and prepare accordingly. When in doubt, leverage our platform and expertise at TokenTax to make filing your DeFi taxes easy.
The first thing to know is that the IRS treats crypto as property, subject to the usual short- and long-term capital gains implications on gains and losses and in some cases regular income tax.
Capital asset vs. income
When looking at DeFi tax, it’s important to understand the difference between capital assets and income. Briefly:
Capital assets are any significant asset an individual owns, including cryptocurrency of any kind. When you sell crypto, stock, artwork, property, or another asset for a profit, you’ve realized capital gains and the IRS requires you to report this. For tax purposes, these gains are subject to capital gains tax.
Income comes from employment or self-employment, dividends, interest, and royalties and is subject to income tax.
Depending on how you use DeFi, you may be subject to capital gains and/or income taxes.
How is DeFi taxed?
The very rudimentary existing IRS guidance about DeFi taxes falls under its general guidance for cryptocurrency as a whole: “When you earn crypto from an asset appreciating in value, you pay taxes on capital gains.” But there’s more to the story.
While the IRS has not yet released specific guidance for DeFi, it has given guidance on crypto taxes for U.S. taxpayers, which naturally also applies to DeFi. Like other crypto transactions, your DeFi activities will be subject to either income or capital gains tax.
Tax professionals are also able to infer from the IRS’ position on crypto generally how various DeFi investments are intended to be taxed. The most important consideration when looking at your tax filing and DeFi transactions is: does the IRS view a given DeFi transaction as relating to a capital asset or as income?
There’s a great deal of nuance and some gray areas here, so read further in this guide to learn more. When in doubt, our team at TokenTax can help you get clarity around all your DeFi tax questions.
Crypto capital gains transactions
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.
Crypto income transactions
Examples of crypto income events include:
Airdrops and hard forks
Wages earned in crypto
Read on for more in our comprehensive guide to DeFi taxes.
DeFi taxes on lending
Lending is one of the key elements of DeFi crypto that makes it appealing to users. With DeFi, it’s possible to use crypto as a collateral for loans. There are DeFi tax consequences to this, which we look at here.
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. If 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 may 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.
Liquidity mining tax explained
Liquidity mining or “yield farming” is an investment strategy through which crypto holders lend assets to a DeFi exchange and receive rewards in return, typically resulting from a share of trading fees on tokens swapped.
Entering a Liquidity Pool
In many cases, when you enter a liquidity pool, you are trading your crypto for a liquidity pool token, which represents your share of the pool. This may result in a taxable event, in which case the usual capital gains rules apply. In other cases you may simply lock (not trade) your coins and claim your rewards token later, which means the taxable event occurs when you claim your reward tokens.
Exiting a Liquidity Pool
Similarly when you exit a liquidity pool and realize gains or losses, this may also be a taxable event. Because the IRS has not given specific guidance on liquidity mining, and they tax coins received from airdrops and forks as income, it’s possible they’ll move similarly on liquidity mining and treat all rewards from it as subject to income rather than capital gains taxes. Because of this ambiguity, some investors choose to be conservative when reporting this on their taxes, while others opt to be more aggressive.
The conservative approach is to treat exchanging crypto for LP tokens as a crypto-to-crypto exchange, incurring capital gains or losses based on how your crypto changed since you first received it.
The aggressive approach is to treat exchanging crypto for LP tokens like a deposit, which the IRS considers a non-taxable event. Essentially this approach argues that true ownership for tax purposes is not transferred upon the generation of LP tokens.The IRS has not released any guidance about providing liquidity to liquidity pools.
Liquidity mining income tax example
You enter a liquidity pool with two ETH worth $3,000, which you purchased over a year before for $1,500. Upon entering the liquidity pool, you receive liquidity pool (LP) tokens worth $3,000. This realizes $1,500 in profit, subject to long-term capital gains by the IRS.
You hold these for six months, while you receive additional LP tokens, which increases the value of your holdings to $3,250.
After six months, the value of your pooled ETH increases to $4,000 and you withdraw your LP tokens from the liquidity pool and realize $1,000 in profit subject to income or capital gains tax. This depends on whether your initial pooled ETH was swapped for another token at the time of pooling or if you trade for the rewards tokens later.
Each DeFi platform that offers liquidity mining will handle transactions differently, so it’s important to take liquidity pool mining taxes on a case by case basis and, if you’re not a U.S. based trader, look into your region’s tax rules around DeFi tax. When in doubt, our experts at TokenTax can help clarify.
Are some DeFi transactions non-taxable?
Many individuals and tax professionals see certain DeFi transactions such as depositing to Aave, wrapping or unwrapping ETH, or entering a liquidity pool as non-taxable. These transactions are a gray area because although they are an exchange of one token for another (e.g. ETH -> aETH), they often have extremely similar properties or the same price. Tax guidance in the U.S. and in many other countries considers crypto to crypto exchanges to be a taxable event.
In the absence of guidance, we cannot recommend one methodology over another. By default, our platform at TokenTax imports these transactions as taxable. However, we do allow people to classify such transactions based on their tax professional's interpretation and in 2021 gave users the ability to reclassify transactions as non-taxable, according to their interpretation via a transaction type called Migration. This kind of transaction will not realize capital gains or losses on the asset being wrapped or unwrapped.
It’s important to note that treating these transactions as non-taxable events will only defer any gains or losses. Once you dispose of the asset in a taxable event, such as a sale, any gain or loss will be triggered at that time.
DeFi staking and interest taxes
DeFi crypto interest and staking earnings can be taxed as either capital gains or income, similar to liquidity mining. 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 grows.
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 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 the increase in value.
However, if you sell the 10,000 SPELL at $.01, you’ll have a capital loss of $100.
Are there gray areas with DeFi taxes?
The IRS hasn’t issued specific guidance on crypto DeFi taxes. Overall the safest way to treat these transactions is as crypto-to-crypto exchanges that result in capital gains or losses or, in some cases, as regular income.
However, depending on your CPA's guidance, you may be able treat wrapped tokens as non-taxable. With TokenTax, you can do this by changing the transaction's type to "migration" instead of "trade" on your All Transactions page.
How are wrapped tokens taxed?
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 DAI, you create yvDAI
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.
How are liquidity pool transfers taxed?
Liquidity pool transfers, like other crypto transfers, are not taxable. Transferring crypto between exchange accounts or wallets are nontaxable events as they are not considered trades of the token.
Transferring your liquidity pool tokens from one wallet to another are treated as self-transfers, just like moving fiat from one bank account you own to another. Note there may be fees associated with withdrawing funds, including an ETH gas fee, which is technically a disposal for your tax purposes.
How is multichain bridging taxed?
Conceptually bridging can be 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.
How are DeFi rebasing tokens taxed?
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. 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.
Best crypto tax software for DeFi
As we’ve seen, DeFi crypto taxes can be complicated. Crypto tax software for DeFi should be top of mind for anyone who’s relied on DeFi for the 2022 tax year and beyond.
TokenTax makes filing all of your crypto taxes, including complicated crypto transactions, easy. With dozens of integrations, an easy-to-use platform, and expert support available, TokenTax serves to take the stress and hassle of DeFi taxes off your plate so you can focus on making the best decisions with your crypto.
With our crypto tax software, you’ll be able to import data from every crypto exchange (CeFi and DeFi), blockchain, protocol, and wallet. Simply sync your transactions via API or upload them in a supported CSV format, and our software will help you calculate your tax consequences. More than a platform, we’re also a full-service crypto tax accounting firm, so you can rely on us to take your annual DeFi tax filing over the line, accurately and on time every time.
Frequently asked questions
Find answers to commonly asked questions about DeFi taxes here.
How do you make money with DeFi?
As outlined in this article, there are a number of ways to make money with DeFi:
Deposit crypto for an annual yield
Each of these will have unique risks and tax consequences, so it’s important to do your research and lean on experts like ours at TokenTax when tax season comes around.
How does the IRS tax DeFi?
The IRS has not at time of writing released specific guidance for DeFi. However, it has given guidance on crypto taxes, which also applies to DeFi. Like other crypto transactions, your DeFi activities will be subject to either income or capital gains tax.
Are there non-taxable DeFi transactions?
Some tax professionals classify certain DeFi transactions as non-taxable. TokenTax allows people to classify such a transaction as a “Migration” based on their tax professional's interpretation. This kind of transaction will not realize capital gains or losses on the asset being wrapped.
What’s the difference between a capital asset vs. income?
A capital gain is an increase in the value of a capital asset. Capital gains are returns earned when you sell an investment for more than the purchase price. Investment income is profit from interest, dividends, and other profits through an investment vehicle. In terms of DeFi, some transactions are classified as capital gains from trading an appreciated crypto, while others may be classified as income on tokens received for staking or minting crypto.
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