Tax implications for DeFi and Yield Farming
Crypto Taxes: The Basics
It is important to know that according to the guidelines issued by the IRS (notice 2014-21), the IRS treat cryptocurrencies (they use the term “virtual currencies”) such as Bitcoin, Ethereum, AAVE, and UNI as property for tax purposes.
This means that crypto transactions in which you sell cryptocurrency for fiat currency, trade BTC for ALTs or ALTs for BTC, or use crypto to purchase goods or services will result in a taxable event. These transactions will result in either a capital gain or a capital loss, depending on whether your crypto investment has appreciated or decreased in value prior to the taxable event.
In addition to capital activity, crypto transactions in the form of mining, betting, airdrop or interest earned will result in ordinary income and will be taxed at ordinary income tax rates (which means there is no potential benefit from long-term capital gains).
DeFi Taxes: It’s Complicated
Decentralized finance (DeFi) is a rapidly growing area of cryptocurrency where public blockchains create financial services without the need for central intermediaries. In short, this allows users to trade, lend and borrow without the fees, restrictions, and restrictions that come with banks and financial institutions.
With the advent of DeFi, the financial system is being transformed before our eyes into an open source one, giving transparent access to capital to individuals around the world with fewer obstacles that they can overcome (apart from the learning curve).
While the activity is decentralized, there are still tax implications that must be taken into account when dealing with trade, lending, borrowing and growing crops. The purpose of this guide is to provide an understanding of how DeFi transactions affect you from a tax perspective.
DeFi Taxes: Lending
DeFi protocols allow users to lend their assets or contribute to liquidity pools. This activity generates a yield or “yield” for the user, which means that the return on lending will result in taxable income. The tax treatment of the return depends on the primary activity. The activity will result in either ordinary income or capital gains.
Ordinary Income Treatment – Earning Benefits:
Interest earned from direct lending activity will be recognized as ordinary income and will be taxed at ordinary income tax rates. For example, you can lend a token and in order to do so, you earn more of that token (interest) directly to your wallet. This type of interest income is similar to what we see with traditional financial institutions and the amount of income recognized is simply the token’s fair market value at the time of receipt.
Capital Gains Processing – Liquidity Pool Tokens:
Recently, DeFi platforms do not actually pay interest directly to the user’s wallet, but rather issue liquidity pool tokens (LPTs). A liquidity pool is basically a collection of tokens that are locked into a smart contract to help facilitate efficient trading. The liquidity aggregator is essentially an automated market maker, and the aggregator’s supply of liquidity helps prevent large swings in the asset’s pricing.
LPTs represent the user’s stake in the pool that provides liquidity to them. The LPT owner is not paid interest as in the ordinary income example above, but the value of their LPT increases as the liquidity pool earns interest. When the LPT is eventually replaced by the crypto asset, a capital gain will be triggered which will be equivalent in value to the appreciation of the LPT.
Suppose Satoshi buys 1 ETH for $500. More than a year later, Satoshi decided to test the DeFi water when the fair market value of 1 ETH was $1,000. Satoshi uses 1 ETH to mint 1 aETH on AAVE. Satoshi will make a capital gain of $500 at this point in time when he exchanges his 1 ETH for 1 aETH as Satoshi has seen a net joining of the fortune. Satoshi has been holding his 1 ETH for more than one year, so these capital gains will have favorable long-term capital gain rates.
Now, Satoshi decides to lend his 1 aETH and starts earning interest. In February, Satoshi earned 0.05 AETH in interest, which is $37.5 at the time of receipt. Satoshi will now have to recognize ordinary income of $37.5. So far, Satoshi has generated long-term capital gains of $500 and ordinary income of $37.5. (Note: If Satoshi holds ETH for less than a year, Satoshi will receive short-term capital gains, which means Satoshi will actually receive $537.5 of ordinary income for the year).
Finally, a few months later, Satoshi exchanged his 1 aETH for 1 ETH. When this transaction takes place, 1 aETH equals $800. Satoshi will now experience a capital loss of $200 because his AETH base was $1,000. Satoshi can use this capital loss to offset some of the $500 capital gains they got in relation to ETH to swap for aETH.
DeFi Taxes: Borrowing
An individual can borrow in US dollars or cryptocurrencies by collateralizing their underlying crypto assets. You will always have to provide more collateral than the principal loan amount in order for the loan to be approved. This type of activity does not result in any tax as this is not a taxable event. In addition, this allows the taxpayer to keep the holding period of the underlying asset intact, which can facilitate long-term capital gains by holding the asset for more than one year.
The reason there is no taxable event is that the money loaned will become due at some point, so the taxpayer has not technically been placed in a better economic position.
However, there are some activities related to cryptocurrency loan that may lead to a taxable event. For example, if the price of the underlying crypto-asset drops significantly, the lending platform where the loan was obtained may have to liquidate your collateral. This forced sale will be taxable and any gains from the sale will result in long-term or short-term capital gains, depending on how long the underlying collateral is held.
DeFi Taxes: Interest Expense
In order to determine if the interest paid on a DeFi loan is deductible, we have to consider the purpose of the loan.
If the purpose of the loan is to use the capital for personal use, the interest expense associated with the loan will not be deducted.
If the purpose of the loan is investment, interest expense can be deducted as investment interest expense if the individual’s total itemized deduction is greater than the standard deduction he or she will receive. These expenses will be reflected on Schedule A of your tax return.
If the entity obtains a crypto loan and uses the funds for commercial purposes, the interest paid by the entity will be treated as normal and necessary business expenses and will be tax deductible.
It is important to note that the IRS has not yet issued specific guidance on the treatment of interest expense related to cryptocurrency loans, so in order to determine the tax treatment, tax professionals must leverage their knowledge of traditional lending principles and apply them to the digital asset space to infer tax implications.
DeFi Taxes: Earning Governance Tokens
A governance token is a token that allows the token holder to help make decisions about the future of the protocol that issued the token. These people have the ability to make proposals and even change the entire protocol management system.
Several DeFi protocols such as Compound, Synthetix, Aave, MakerDAO, and MStable distribute governance tokens. These codes are subject to tax upon receipt. Taxable income equals the fair market value of the token at the time of receipt. The distribution of these codes will tax the individual at the ordinary income tax rate.
After receiving the governance token, an individual may wish to sell the token in the market for a different crypto asset, or may wish to sell for US dollars or a stable token. This subsequent sale may result in either a capital gain or a loss, which will be short term or long term depending on how long the underlying governance token is held.
DeFi Taxes: Growing Yield
Yield farming is also referred to as liquidity mining. Yield farming provides a way to generate rewards, or “return,” from crypto assets. A yield farmer effectively secures his digital assets to earn a return on the underlying crypto asset. Crop growers will look for the highest yield across several protocols in an effort to increase their yield or “yield”. Crop growers have the ability to “stack” their crops and earn a higher rate of return. Crop farmers typically use a DeFi app to earn revenue in their DeFi projects token, but there are many different ways to get a ‘return’.
From a tax perspective, when a yielding farmer distributes tokens and receives his reward, the tokens are taxed as ordinary income based on the fair market value at the time of receipt. When the subsequent disposition of the asset occurs, the yield farmer will now have capital activity and will have either a capital gain or a loss, depending on whether the token is appreciated or depreciated from the time of receipt.
DeFi Taxes: Gas Fees
Gas refers to the fee required to successfully conduct a transaction or perform a contract on the Ethereum blockchain platform. Gas fees are usually priced in small portions of ETH, referred to as gwei.
Gas fees can be used to reduce the total returns received when the swap is executed. The gas fee can also be used to add to the cost basis by the total US dollar value spent to facilitate the base transaction.