The potential to earn rewards (in addition to returns) is a major driver of investment activity in the DeFi space. Yield farming, or investment strategies that center on rewards income, has surged, with some traders significantly amplifying their earnings by staking or providing liquidity. Rewards are not tax-free. Just like regular income or interest from a bank, they are subject to taxation. Despite the field’s complexity, reporting rewards earnings is usually relatively straightforward: most crypto rewards are taxed as income.
However, some exceptions and questions exist. Read on for our run-down on how crypto rewards are taxed.
How are crypto rewards taxed? Most crypto rewards earnings are taxed as income.
As stated above, when they are earned, most crypto rewards for staking or providing liquidity are taxed as income. This applies to governance and incentive tokens earned as bonuses, as well as to most interest-bearing tokens. Common tokens that are taxed as income when received as rewards or interest include:
You stake $5,000 of USDC to AAVE and receive $5,000 worth aUSDC in return.
If AAVE is offering 3.87% interest for lending USDC for a one-year term, you would receive interest of $193.49 worth of aUSDC.
You now owe regular income tax on $193.49 of interest income.
The cost basis for the 193.49 aUSDC is thus established at $193.49. You realize any capital gain or loss when you sell, exchange, or spend it.
Many practitioners believe that these staking rewards taxes are incurred they are deposited into a user’s wallet, though there has been no concrete guidance from the IRS on this particular topic. On the Form 1040 Schedule 1, these deposits would be reported at their USD value during the tax year a user “earned” them. This treatment likely applies to income earned from a smart contract’s deposit of additional interest-bearing tokens. For example, if you received $30 of CRO as a staking reward and did not sell or exchange it, at the end of the tax year, you would be taxed on $30 of income regardless of those tokens’ current value, even if they ultimately represented a loss.
Exceptions: cTokens and yTokens may be taxed as capital gains
While most DeFi platforms issue additional tokens as a lender’s interest accrues, on Compound, interest on a deposit is represented by an increase in value in the cToken that represents said deposit. In light of this, many crypto tax accountants interpret increases in the value of cTokens are taxed as capital gains, not as income. If—after receiving guidance from a tax advisor—you chose this tax treatment, you would report the increase/decrease of a cToken’s original value as a capital gain/loss on Form 8949.
You lend 10,000 DAI to COMP and receive $10,000 worth of cDAI in return.
If COMP is offering an interest rate of 2.49% for a one year term, the value of your cDAI would increase by $249.10.
If you were to sell, exchange, or spend your cDAI at the end of the one-year term, you would now be liable for capital gains tax on the $249.10 increase in its value.
yTokens the interest-bearing token of the Yearn Protocol, receive the same treatment.
Is minting an interest-bearing token a taxable event?
The IRS has not provided guidance on whether minting interest-bearing tokens (such as aTokens and cTokens) or transfers into or out of liquidity pools are considered taxable events.
It is possible that these events would be considered crypto-to-crypto trades; in this case, a trader would realize capital gains on the underlying asset minted into an interest-bearing token or LP token equivalent. However, it is also possible to interpret such activities as non-taxable migrations. As such, we recommend you consult your cryptocurrency tax accountant for more guidance. For more on this issue, visit our guide to DeFi taxes.