Take a closer look at some DeFi transactions and learn how US tax principles likely apply.
The explosion in decentralized finance (DeFi) has created a new ecosystem of investment opportunities limited only by the programming prowess and economic creativity of developers.
Although the United Kingdom’s HMRC recently published guidance on the treatment of DeFi transactions, the IRS still hasn’t released any authoritative guidance on the matter.
Unpacking DeFi tax treatment in the US can be difficult. In this article, we take a closer look at some DeFi transactions and discuss how US tax principles likely apply. Because some terms in DeFi are used in various ways, we provide definitions of the activities for clarity.
The UK guidance provides basic information on lending and staking activities in DeFi, including whether the transfer of crypto to a liquidity pool constitutes a taxable disposition and whether the return received from DeFi investing is in the nature of income or the nature of capital. As the guidance explains, the difference is based on the economics of how the transaction is structured.
As in the UK, income taxation in the US is guided by the economics of the activity more than the formal structure of that activity.
In the US, returns received from investments generally can be categorized as income subject to one of the following:
Ordinary tax rates
Or, gain on a capital asset which only needs to be recognized when you dispose of the asset
Cryptocurrency is taxed as property in the US. Unlike specific types of property, such as securities or commodities, there aren’t any niche tax rules, such as the wash sale rule or securities-lending provisions in Section 1058, that apply to cryptocurrency as of February 2022.
If you receive crypto, or another digital asset, as part of a DeFi transaction in return for goods or services, that crypto is going to be considered and taxed as ordinary income by the IRS.
If it increases in value, the gain you recognize at a later date when you sell or dispose of it will be taxed as a capital gain.
A swap is the exchange of one crypto for another through an autonomous DeFi protocol. From a tax perspective, it’s no different than a crypto-to-crypto trade on a centralized exchange.
A crypto swap is simply the disposition of one asset, which will result in capital gain or loss, and the acquisition of another asset. The value of the acquired asset will determine both the proceeds of the disposed crypto and the cost basis of the crypto received.
Yield farming, sometimes referred to as liquidity farming, is a very broad term in the DeFi space. It can relate to several different activities, but generally involves earning some sort of return on the crypto units you own.
Under the umbrella of yield farming, there are two basic activities—lending and staking. Despite the use of these terms, they don’t always reflect the true economics of DeFi transactions.
Crypto staking is the process of temporarily locking cryptocurrency in a specified wallet to activate software and become a validator for a proof-of-stake (PoS) blockchain.
Staking is sometimes used to describe depositing crypto units into a liquidity pool, but it's more appropriately associated with transaction validation on PoS networks.
To learn more about crypto staking, including how it works and how it’s taxed, please read our article.
Putting your crypto into a liquidity pool shouldn’t be considered traditional lending under US tax principles and is likely considered a taxable disposition.
US tax principles focus on the economics of what’s occurring during transactions rather than the labels given to those activities. When it comes to liquidity pools in the DeFi space, some commentators compare it to lending, but it’s still different from typical property lending.
Crypto is taxed as property, not currency. Lending crypto is taxed differently than lending cash. When we lend cash, there isn’t a taxable event because cash isn’t property.
Even lending out property, like your car or house, isn’t a taxable disposition of your car or house. You’re just allowing someone else to use it for a period of time, and they’ll compensate you in return. While it’s in their possession, they can’t sell it or alter it; they can only use it.
When you place crypto into a liquidity pool, users of that pool aren’t using your crypto; they’re acquiring it and selling it to other users of the pool through swaps. You’re often giving up control of your units and agreeing to receive equivalent units or value in return at a later date.
Under US tax principles, when you give up beneficial ownership of property, that’s a taxable disposition of that property, even if there’s an agreement to return equivalent property to you at a future date.
By placing units in a pool, you’ve relinquished ownership of your units to the pool, which generally is considered a taxable disposition of those units—the same as if you were to relinquish ownership of property. Because it’s a disposition, you’ll recognize a capital gain or loss on those units depending on the asset’s cost basis.
When you exit the pool, you’ll reacquire new units, and the cost basis will be set equal to the value of liquidity you removed from the pool. If the value of your liquidity changes while you’re invested in the pool, you may have a gain or loss with respect to the liquidity tokens or NFT that you’re holding as a representation of your investment in the liquidity pool.
When a stock share is lent out in a securities loan, the lender relinquishes complete ownership of that share, and the borrower acquires ownership of it typically to sell in a separate transaction. But securities loans aren’t taxable because of a special provision in Section 1058 of the US tax code. Even though liquidity pool transactions are secured in a similar manner to securities lending, no such provision currently exists for crypto.
This is a situation where an existing rule for securities lending provides a tax benefit that crypto users can’t use. However, there are situations where the exact opposite is true. For example, the wash-sale rule applies to securities and prohibits tax-loss harvesting, but doesn’t apply to crypto, so crypto traders can still benefit from this investment strategy.
While holding liquidity in a pool, you typically earn yield from that pool. Many people refer to this yield as interest, but under US tax law it isn’t interest despite being conceptually similar.
The distinction is important; interest earned or paid is given special treatment under the tax code, so mischaracterizing yield as interest may result in improper tax reporting.
Under the tax code and case law, interest is compensation paid for the use of cash, not property. In the crypto ecosystem, yield represents compensation for the use of crypto rather than cash.
Yield is generally treated as ordinary income. When a return is based on some contractual right to receive the return, it’s treated as income. Liquidity pools run off smart contracts. Those contracts dictate what yield a user contributing to a pool will receive, the same way a physical contract would.
As ordinary income, the fair market value of the yield received should be reported as income at the time of receipt. The amount reported as income also sets cost basis for the crypto received as yield. The cost basis will be used in the future to determine whether you have a capital gain or loss on the asset when it’s disposed.
Recently, creative developers have begun building DeFi products that attempt to convert yield into capital appreciation. This is done by having the protocol essentially treat the yield as appreciation in the value of a user’s liquidity in the pool.
For example, yield is generally received in terms of units of crypto, which are treated as income upon receipt. In these tax-advantaged protocols, time is marked at the moment the crypto is contributed to the pool.
While in the pool, yield is reflected not through additional units received but through a time-based increase in the fiat value of the original units contributed. As a result, when the pool is exited, the units haven’t changed, but the value has; that change in value reflects the yield earned, but it’s captured as capital gain for tax purposes rather than ordinary income through additional units received.
To facilitate this time-based value increase, the protocol generally requires an additional step of wrapping the relevant crypto to create an augmented version of the original crypto that allows for the time-based value increases.
It isn’t clear whether these tax-efficient products will withstand IRS scrutiny. The tax code, in Section 1258, already includes special provisions to prohibit similar approaches to converting income to gain in the context of traditional financial products.
Under those provisions, the apparent capital appreciation still gets taxed as ordinary income.
When transferring units across the blockchain and into or out of a DeFi protocol, you will incur transaction fees, commonly known as gas fees.
Under the tax code, the treatment of those fees is basically split into two groups:
Fees incurred in conjunction with the direct acquisition or disposition of crypto
Fees incurred with respect to transferring units across the blockchain as part of general investing activity
Fees incurred in conjunction with the direct acquisition or disposition of crypto will be incorporated as cost basis in crypto acquired or used to offset proceeds received from the disposition of crypto.
Trade 1 ether (ETH) for 5000 basic attention tokens (BAT) with a gas fee of 0.01 ETH
5000 BAT Cost basis = 1.01 ETH Market Value
In this scenario, the fee of 0.01 ETH provides a benefit by increasing the cost basis of the acquired BAT. In other scenarios, the fee may also provide a benefit by reducing the proceeds of the disposed units.
Fees incurred with respect to transferring units across the blockchain as part of general investing activity currently provide no tax benefit.
Transfer 1 ETH from one wallet to another with a gas fee of 0.01 ETH
1 ETH cost basis stays the same
0.01 ETH gas fee is treated as an investment expense that isn’t currently deductible
Prior to 2018, investment expenses could be deducted as miscellaneous itemized deductions. But, beginning with the 2018 tax year, this deduction was eliminated as part of the Tax Cuts and Jobs Act (TCJA).
Keeping up with all the paperwork and reporting regulations for digital asset transactions can be laborious and time-consuming. The more complex your crypto portfolio becomes, the more complicated your tax liabilities can get.
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