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How Uniswap or Defi will affect your taxes

In the Ethereum community, DeFi, or Decentralized Finance, is all the rage. Many DeFi lending products have been built on top of the ERC-20 standard, and Uniswap is one such project that has recently captured the imagination of Ethereum enthusiasts.

Inspired by Ethereum founder Vitalik Buterin, Hayden Adams taught himself Solidity, got a grant from the Ethereum foundation, and created Uniswap. Uniswap is a protocol for automated token exchange on Ethereum. Unlike the current centralized or decentralized exchanges, Uniswap operates completely via smart contract.

It’s a completely on-chain market maker that allows swapping of ETH for ERC20 tokens, ERC20 tokens for ETH, and swapping ERC20 tokens against each other. Uniswap users can also participate in the liquidity pool of any token and gain commissions for it. In that sense, ETH or ERC20 Hodlers can earn passive income.

In short you can interact with Uniswap in a handful of ways:

  • Deposit ETH or an ERC20 token in the liquidity pool, here is where you can gain commissions in Uniswap liquidity token

  • Trading your earned liquidity token while your deposit is still in the liquidity pool

  • Swapping ETH for ERC20 Token

  • Swapping ERC20 Token for ETH

  • Swapping ERC20 Token for ERC20 Token

So let’s analyze these from a tax perspective, we are TokenTax after all. Please note, the IRS has not made any official guidance as to Uniswap, therefore confirm any advice with your tax professional.

Depositing into the Liquidity Pool

This is likely not a taxable event. You have not sold your holdings, you are basically “lending” them to the pool. This would be akin to leaving your watch at a pawn shop, or even taking a home-equity loan against a house you own.

Trading Liquidity Token while your Deposit remains in the pool

Any trade you make would be a taxable event. The cost basis would either be determined by the liquidity token income you reported. Your subsequent trades would have an associated loss or gain relative to that income. This is very similar to mining crypto, which would be reported as income, and thereafter set the cost basis level whenever that mined crypto was sold -- resulting in either a capital gain or capital loss.

Arguments have been put forth to not report liquidity token income when earned due to the difficulty in tracking it, and instead report the full gain with a $0 cost basis when it is eventually sold.

Swapping ETH for ERC20

This is taxable, similar to how it would be taxable on any other exchange. Your ETH position has a loss or gain depending on the entry level.

Swapping ERC20 for ETH

This is taxable, similar to how it would be taxable on any other exchange. Your ERC20 position has a loss of gain depending on the entry level.

Swapping ERC20 for ERC20

This is taxable, similar to how it would be taxable on any other exchange. But there’s a twist: this is actually two transactions. On the Uniswap front end, it looks like one trade; however, it is actually two. The trades occurring are actually ERC20 to ETH and ETH to ERC20. Each of those trades are taxable, with the first trade being the one with the largest potential tax liability since the second trade does not have a large time lapse. Although in times if extreme volatility, there can be a larger tax liability incurred.

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