It’s no secret that DeFi has seen a massive influx of users in 2020. Individuals seeking to gain financial upside, or yield, on their crypto holdings are flocking to decentralized platforms such as Uniswap, Compound, Maker, and many others. In addition to earning yield, decentralized exchange and other use cases are fueling the DeFi demand. With this flurry of new crypto activity comes the question: What are the tax implications of these new DeFi transactions?
In this guide, we’ll break down the tax implications of DeFi by looking at existing cryptocurrency tax guidance within the U.S.
This guide was created in-tandem with the tax professionals at CryptoTrader.Tax.
The Basics of Cryptocurrency Taxes
In the U.S. and many other countries around the world, cryptocurrencies are treated as property for tax purposes. This means that capital gains and capital loss reporting rules apply to cryptocurrencies just like they do with other forms of property such as stocks, bonds, and real-estate.
Simply put, when you dispose of a cryptocurrency (i.e. get rid of it) by selling it or trading it for another cryptocurrency, you realize a capital gain or loss that needs to be reported on your taxes.
For example, if you purchased 0.1 BTC for $2,000 in May of 2018 and then sold it two months later for $3,000, you would have a $1,000 capital gain. You report this gain on your tax return, and depending on what tax bracket you fall under, you pay a certain percentage of tax on the gain. Rates fluctuate based on your tax bracket as well as depending on whether it was a short term vs. a long term gain. This applies for all cryptocurrencies.
In addition to capital gains, if you earn cryptocurrency—whether that is from a job, from mining or staking rewards, or from interest from a loan, you recognize income equal to the fair market value of the cryptocurrency at the time it was received. We dive further into this below.
John earns 0.5 BTC on a freelance project he took on from a client. At the time of receipt, 0.5 BTC is worth $5,000. In this case, John recognizes $5,000 worth of income as a result of this event. The same would hold true if John earned that BTC from mining, staking, or interest payments.
Decentralized finance (DeFi) enables access to traditional financial services such as trading, lending, and borrowing without incurring the costs and frictions associated with traditional rent-seeking middlemen (banks and financial institutions).
The vast majority of popular DeFi platforms today are built within the Ethereum ecosystem, and some unique technological advancements such as Automated Market Making (AMM) and Liquidity Pools enable the “decentralized” capabilities of many of the most popular DeFi platforms today.
However, just like in the Centralized Finance world (CeFi), there are tax implications for trading, lending, borrowing, and earning interest—even if it’s in the form of cryptocurrency. We dive into these further below.
DeFi Tax Overview
Whether you are earning interest, swapping coins via Uniswap, yield farming, or receiving governance tokens as a reward mechanism, your defi-related income will be classified in one of two ways:
- Ordinary income, or
- Capital gains income
Ordinary income comes from income that you earn—like from a job or other means. It is simply taxed at your marginal tax bracket. Because of this, ordinary income doesn’t carry significant tax savings opportunities.
Capital gains income is income that comes from the appreciation of your investments in capital assets (like cryptocurrencies or stocks). Capital gains income carries significant tax savings benefits. The first benefit of capital gains income is the long-term capital gains tax rates, which you qualify for if you held your asset for longer than 12 months. Long term capital gains tax rates are significantly less than short term capital gains rates and can save you a lot of money in taxes owed if you strategically plan for them.
Let’s apply these two various income types to common DeFi transaction scenarios.
Lending and Contributing to Liquidity Pools
Platforms like Compound, Uniswap, Blanancer and others allow you to lend out your cryptocurrencies or contribute to liquidity pools to earn a return on your money, often referred to as yield.
Interest earned directly from your cryptocurrency loans is treated as income. The amount of income you recognize from your interest is simply the US Dollar fair market value of the cryptocurrency at the time it is received.
Many popular DeFI platforms today however don’t actually pay your interest directly to your wallet. Rather, they issue you Liquidity Pool Tokens (LPT’s) that represent your stake in the pool. The interest that accrues to the pool makes your LPT’s more valuable. Then when you ultimately trade your LPT’s back for the underlying asset, you trigger a capital gain as this is treated as a crypto-crypto trade.
- Robert buys 0.5 ETH for $100. Two months later, he converts 0.5 ETH (which is now worth $150) to cETH via Compound. At this point, Robert recognizes a $50 capital gain for exchanging his ETH for cETH.
- As Roberts ETH starts to earn interest in the pool, his cETH becomes more valuable.
- Two months later, Robert converts his cETH back to ETH and receives $170 worth of ETH ($20 more than his original $150 of ETH that he put in)
- Robert recognizes a $20 capital gain by trading his cETH for ETH (170 - 150).
In the above example, the interest accrued from lending out your ETH accrued to the pool resulted in capital gains income when trading cETH back to ETH.
For other DeFi platforms such as Aave, you earn interest directly to your wallet address. This interest is treated as income—not capital gains.
- George buys 1 ETH for $300. A few months later when that 1 ETH is worth $400, George uses it to mint 1 aETH. At this point, George recognizes a $100 capital gain by trading his 1 ETH for 1 aETH.
- George now lends via his aETH, and earns 0.1 aETH as interest on May 9 which is worth $30 at the time. George recognizes $30 worth of ordinary income.
- One month later, George converts 1 aETH back to 1 ETH. At the time of conversion, 1 aETH is worth $300. Here, George would incur a $100 capital loss by trading his aETH for ETH—as his cost basis in that 1 aETH was $400 (400 - 300 = 100).
When looking at lending activities within DeFi, it’s important to assess how the interest is accruing. If it is being paid out directly to you, it is ordinary income. Contrary, if the interest rewards are accruing to the pool of which you have an LPT stake in, the income is treated as capital gains when you convert your LPT back to the underlying asset.
For more information discussing the tax implications of specific DeFi protocols, refer to this DeFi Tax Guide.
DeFi Token Swaps
Swapping one token for another on platforms such as Uniswap is no different from a tax perspective than a crypto-crypto trade on a centralized exchange.
If you trade ETH for another token on Uniswap, that is treated as a disposition of your ETH, and any gains or losses accrued on your ETH are realized at this point in time.
Tom purchases 1 ETH for $400. Two months later, Tom swaps this 1 ETH on Uniswap for 300 USDT. At the time of the swap, 300 USDT was worth $300.
In this example, Tom would incur a $100 capital loss upon disposing of his ETH for USDT. This loss would get reported on his taxes and would deduct from his other capital gains.
DeFi Governance and Incentive Tokens
Many DeFi platforms incentivize lenders and borrowers by rewarding them with their own incentive or governance token, like Compound’s $COMP.
Any governance token that you receive for contributing to a protocol is treated as income. The amount of income recognized is the fair market value of the governance token at the time of receipt.
Lesley lends ETH on Compound. In return for participating in the protocol, Lesley receives 1 $COMP as a reward. At the time of receipt, this 1 $COMP is worth $100. Lesley would recognize $100 of income from this receipt of $COMP.
DeFi Airdrops - $UNI
The IRS makes it clear that airdrops are to be treated as income at the time you take possession of the airdropped cryptocurrency.
In the case of Uniswap, the $UNI airdrop issued on Sept. 16, 2020 was worth hundreds of millions of dollars for early adopters of the decentralized exchange. If you were one of the 150,000 that claimed UNI tokens via the airdrop, you are liable for income taxes on the USD equivalent of the amount received.
Suppose you received 400 UNI tokens from the Uniswap airdrop. At the time you claimed them, UNI was worth $3.5. In this case, you would recognize $1,400 of ordinary income from this airdrop (400 * $3.5). Depending on your marginal tax bracket, you would owe a percentage of this in income taxes.
Beware - if the value of UNI drops after you take possession of the tokens, you still owe taxes on the original value of the amount received. For individuals who do not convert any UNI to USD, this can create a tax predicament as you could potentially owe more in taxes than your UNI is worth (if the value of UNI drops significantly).
How Do You Report DeFi Income On Your Taxes?
In the U.S., all capital gains income gets reported on IRS Form 8949. Each cryptocurrency disposal (trade or sell) gets reported individually on this form. All gains and losses are summed together to arrive at a net capital gain or loss for the tax year.
Income earned from the interest on your cryptocurrency deposits/collateral should be reported under the “other income” section of line 21 of Schedule 1 — Additional Income and Adjustments to Income as part of your income tax return.
Cryptocurrency Tax Software
Cryptocurrency tax software tools like CryptoTrader.Tax can help automate your DeFi tax reporting. By integrating directly with platforms such as Uniswap, Compound, and others, you can use crypto tax software to import your transaction history and generate your capital gains and income tax reports with the click of a button.
In the U.S. and most countries around the world, income is taxable. This is true whether you earn income from your job as a marketer or from investing in the latest DeFi protocols. It’s important to keep close records of your crypto activity so that you can easily report it with your year-end tax return.