As you may be aware, the Internal Revenue Service typically considers cryptocurrencies an investment property rather than cash. The purchase of bitcoin is not considered a taxable event. You may purchase it and keep it for as long as you like without incurring any taxes. You only pay taxes when you realize a profit or a loss, just as you do when you sell a stock or other property to make a profit.
It implies that if you sell your cryptocurrency or use it to purchase, you will be subject to capital gains tax. To calculate your profit, you’ll deduct the amount you spent for the currency from the currency’s current market value. You may also be able to claim a loss if you sold your cryptocurrency for less than what you paid for it. Trading one form of cryptocurrency for another is also considered a taxable event.
Examine the concept of Decentralized Finance and taxation of your interactions using DeFi protocols. The topics covered in this guide include the introduction to Decentralized Finance, Yield Farming Taxes, DeFi 2021 Crypto Taxes Overview, DeFi Lending and Liquidity Pool Taxes, DeFi Loans and Borrowing Taxes, cToken, aToken, and yToken Tax Guidelines, Earning Governance Tokens Taxes, Earning and Paying Interest Taxes, Liquidation Taxes, DeFi Platforms Tax Tips, and Gas Fees Taxes. Thus, keep reading this article to get full insights into the crypto world and its taxation.
What is Decentralized Finance (DeFi)?
The term “decentralized finance,” often known as “DeFi,” was coined in a Telegram conversation in 2018. Those were the days when an intrepid group of software engineers and entrepreneurs struggled to develop a name for their movement of new-breed financial services that would be automated, founded on blockchain technology, and capable of displacing established financial institutions.
DeFi is now a multibillion-dollar market three years after its inception. A user who has a cryptocurrency wallet may do various activities, including trading digital assets, getting loans, and taking out insurance. More than 10 million users, for instance, have downloaded MetaMask, one of the most popular digital wallets used to get access to these networks.
Decentralized Finance (abbreviated as DeFi) is an umbrella word that refers to a diverse range of applications and initiatives in the public blockchain environment to disrupt the existing financial sector. DeFi, derived from blockchain technology, is defined as financial applications based on blockchain technologies that often use smart contracts. Smart contracts are mutually binding agreements that are automatically executed and do not need the involvement of a third party. Anyone with an internet connection may access them.
Decentralized Finance (DeFi) is a collection of apps and peer-to-peer protocols created on decentralized blockchain networks that do not need access rights to facilitate financial instruments’ lending, borrowing, and trading. The Ethereum network is used to build most DeFi apps today. Still, many other public networks are developing that provide faster performance, more scalability, greater security, and lower prices.
Decentralized Finance enables merchants to have access to services such as crypto-like buying, selling, or trading without the need for the involvement of any third party or intermediaries like Coinbase, etc. Decentralized exchanges like Uniswap use automated market-making. It implies that instead of relying on an exchange’s order book, trades use the liquidity provided by ordinary traders. Ordinary traders pool their holdings together in a liquidity pool to fill trades.
Decentralized finance apps seek to deliver services that are usually centralized, such as loans and currency exchanges, over a more efficient, free, and decentralized platform by removing the need for intermediaries in transactions.
Yield Farming Taxes
When you deposit money in your account, you loan to the institution to acquire an interest amount. Yield farming, also referred to as yield harvesting, is giving cryptocurrency in exchange for an additional percentage in return. In exchange, you earn an interest amount and, on occasion, fees. However, the fees earned from yield farming are insignificant compared to accompanying interest payments with additional units of the coin. If the currency grows in value at a quick pace, real money will be made.
The popularity of this new phenomenon known as yield farming has recently skyrocketed. Putting your crypto assets to work is what yield farming is all about; it’s a technique of maximizing your profits. Examples include consumers depositing their crypto assets in a DeFi protocol like Compound and earning reward tokens equivalent to interest, which are loaned out to other DeFi platforms to earn even more rewards. Compound is one such system. The purpose of yield farming is to put down some initial money and then utilize leverage and arbitrage tactics to maximize the amount of interest received on that capital.
Yield farming is a general term that refers to an endeavor to put your cryptocurrency holdings to work to create the highest potential returns on those assets. Simply said, yield farmers who use yield farming tactics may transfer assets inside multiple distinct DeFi protocols, continually searching for the pool that provides the highest yield from week to week.
There are other decentralized money marketplaces, such as Uniswap, and others that are similar, that are available. Based on the platform, these protocols enable you to combine crypto resources into contracts that can then be utilized for liquidity exchange or giving to borrowers. Suppose you supply liquidity in an application, such as Uniswap, or for providing purposes, such as Aave. In that case, you will be compensated by the fees collected from people who utilize this liquidity for swapping tokens and loan transactions. Because the rate of return on this liquidity changes based on demand, yield farmers are continuously looking for opportunities to reallocate to areas where they may earn the highest return rate.
It shouldn’t come as much of a surprise to anybody. Fundamentally, cryptocurrencies are classified as “property” by the Internal Revenue Service. Also, general tax principles that apply to property transactions apply to your cryptocurrency transactions. Every time you earn, spend, sell, or trade a crypto asset, you are triggering a taxable event reportable on your tax return.
DeFi 2021 Crypto Taxes Overview
It is assumed that the market valuation of DeFi, or Decentralized Finance, will continue to experience ongoing adoption, thanks to its meteoric rise in the previous few years. DeFi may revolutionize Finance by letting people lend, trade, and perform other financial activities without the need for a middleman or central authority.
DeFi transactions are gaining popularity, but the Internal Revenue Service has not yet issued precise instructions on how they should be considered tax-wise. A few brief comments have been mentioned on how some transactions made on DeFi platforms should be taxed according to IRS Notice 2014-21, first released in 2014 and revised this year.
For federal tax purposes, cryptocurrencies are classified as property, according to IRS Notice 2014-21. In other words, a taxpayer who sells cryptocurrency will have a capital gain or loss equal to the difference between the price they paid for the coin (including fees and other transaction charges) and its fair market value at the time of sale. As with any other asset, if you sell your cryptocurrency after holding it for more than a year, you will be subject to long-term capital gain rates (a federal maximum rate of 20 percent). You can also get short-term capital gain rates (a federal maximum rate of 37 percent) if you hold it for less time.
Stakes in Decentralized Financing
Secure crypto assets in a smart contract with DeFi staking and become a “validator” on the Proof-of-Stake (PoS) blockchain network in return for doing so. The correctness of transactions inside a block is verified by validators in PoS systems since there is no financial intermediary to handle and audit transactions. Tokens from the platform are given to validators for each block approved and declared legitimate by the blockchain network. On the other hand, Validators risk losing their staked crypto assets if they fail to verify a block correctly. Validators are motivated to enforce the rules on the platform because they stand to lose their staked crypto assets and receive incentives, which protects the DeFi network’s integrity.
A validator could be viewed as providing services, for example, certifying the correctness of transactions inside a block – in return for tokens of the platform, according to the principles put forth by the IRS in the notice. As a result, any token payout would be considered ordinary income by the validator. The IRS has commented specifically on Proof of Work and mining, so it is possible to use these comments as guidance for staking taxes. How the loss of crypto assets staked should be addressed from a tax point of view is less apparent.
Decentralized Liquidity Pool Taxes
The addition of liquidity to a crypto pool will most likely be seen as a taxable event. It is potentially taxable because of the token pair supplied in exchange for liquidity. Similarly, it is possible that removing liquidity will be viewed as a taxable event due to the liquidity pool token.
Anyone is able to join the automated market making of a Decentralized Finance platform such as Aave by offering liquidity to token pairings. Liquidity pools are a kind of decentralized exchange that allows anyone to participate in automated market making. If you want to contribute liquidity to the USDC-ETH pair on Uniswap, you may do so and get a portion of the liquidity pool in return. As a reward for your participation, you will earn a percentage of the fees collected in this pool. It can be expected that the earnings from these pools will be considered taxable income once tax authorities comment on the topic.
Tokens for the liquidity pools are issued to participants that provide liquidity to the pool (LP-token). If you look at it from a tax standpoint, each exchange of trading pair tokens for LP tokens that you put into the liquidity pool might be deemed a taxable transaction for tax purposes. Removing liquidity from the crypto pool by exchanging the LP-token for the two tokens you get from the pools refers to exchanging your LP tokens back for your original tokens in what may be seen as a taxable event.
You will be subject to taxation on any income you get due to your lending activity. If you utilize the DeFi platform, your income will be either ordinary income or capital gains income.
Income from Capital Gains
It is possible to save a substantial amount of money on capital gains. Long-term capital gains tax rates, which you qualify for if you have owned your asset for more than 12 months, are the initial advantage of capital gains income. Because long-term capital gains tax rates are much lower than short-term capital gains tax rates, carefully planning for them may save you a large amount of money in tax liabilities. Furthermore, capital gains income may be fully offset by capital losses, but capital losses cannot completely offset ordinary income.
When comparing income in Decentralized Financing capital to ordinary income
Lending services in the conventional world, and even in the controlled cryptocurrency arena, often pay interest in the same currency you paid them in exchange for the loan. Using an example will make things clearer for you. It is similar to the interest you earn from a bank or the cryptocurrency interest you receive from a crypto lending site like BlockFi.
As a result, the interest that you earn is considered regular income under the tax code. With this in mind, if you get crypto tokens in exchange for lending, such as when your wallet balance grows due to interest income, you should treat this as ordinary income.
Many new DeFi protocols, on the other hand, reward you with Liquidity Pool Tokens (LPTs) in exchange for lending them your cryptocurrency. These LPTs indicate the fraction of your interest in the liquidity pool that has been allocated to you. If you engage with the protocol, you may receive capital gains income rather than ordinary income due to your interactions.
The reason for this is that contributing your tokens to a liquidity pool and getting LPTs is organized in the same way as a trade or token exchange. In other cases, like cTokens, the value of your investment in the liquidity pool grows as interest is accrued in the pool. However, you aren’t truly compensated for this interest in the traditional sense.
On the contrary, the value of your LPTs (cTokens) grows as interest is accrued, but the number of LPTs you hold remains constant. When you exchange your LPTs back for the underlying asset, you generate a capital gain equal to the amount of appreciation in value that the LPTs have accumulated, which is regarded as capital gains income in the year that the swap occurs.
Taxation when borrowing or having DeFi Loans
Up to this point, we’ve spoken about how lending money to DeFi markets affects your tax liability, but it’s also possible to borrow cryptocurrency via a DeFi exchange. The tax ramifications are a bit murky, though, mostly because the Internal Revenue Service has not yet defined any precise regulations for borrowing or lending cryptocurrency via a decentralized exchange (DeFi).
Consequently, most certified public accountants (CPAs) are now following the previously set criteria for conventional forms of lending. The act of borrowing will not affect your taxes, but the act of repaying the debt will. A firm that takes out a cryptocurrency loan to cover business expenditures may deduct the interest paid on the loan as normal. Interest paid on personal loans, on the other hand, is normally not deductible from income. If you utilize borrowed cryptocurrency to make further cryptocurrency investments, the interest you pay on the first loan may be deductible as an investment expenditure. However, as is often the case, the Internal Revenue Service restricts investment costs, disallowing expenses that exceed your investment income.
Because the borrower retains economic ownership of the collateral at all times, the deposit of collateral is not likely to constitute a taxable event in the eyes of the IRS. The transaction will be recognized as a sale if it includes a token exchange and is subject to taxation.
It is not taxable to receive the payout of the loan and make the principal repayment as long as both the value and denomination of the principal payback are the same.
Whether you can deduct interest payments from your income depends on the purpose of the loan. A loan obtained by a firm for commercial reasons may be deductible as a business cost if the loan is used for such purposes.
As previously stated, the Internal Revenue Service has not yet issued explicit guidelines on interest payments in cryptocurrency lending. Consider conventional lending instead of alternative lending to obtain an understanding of how they may be regarded.
If a firm takes out a loan for a commercial reason, the interest paid on the loan is recognized as a genuine business cost that is tax-deductible. For personal reasons, interest expenses are generally not considered tax-deductible when loans are taken out.
If you employ the borrowed money for investment purposes, the interest expenditure you incur is categorized as investment interest expense rather than interest charge on borrowed funds. In addition, investment interest expenditures are subject to particular tax laws and may only be deducted up to the amount of your net investment income.
Collateralized Tokens Taxation
Many DeFi systems have their tokens that reflect the amounts in their protocols, called “tokens.” The Compound and Aave platforms both support these tokens.
Profits from these processes may result in ordinary or capital gain income depending on your situation. Suppose you consider allocations into these types of tokens as taxable transactions. In that case, you will be required to report any capital profit or loss on such assets that are exchanged for corresponding cToken counterparts on your tax return. It is recommended to seek the advice of a tax specialist.
Due to a market’s interest-earning ability, a rising amount of the primary asset may be converted into the cToken. Because you are earning interest with these tokens, you are not getting more cTokens; instead, your cTokens amount — which reflects your part of the protocol’s worth — is increasing.
From a taxation viewpoint, when you sell your cTokens and swap them for the primary cryptocurrencies, your income is recognized as capital rather than ordinary, as would be the case if you were earning conventional interest income. This is provided that the initial exchange for the C-tokens was also considered a taxable event subject to capital gains. There is currently no guidance on this issue.
Aave’s aTokens, similar to aDAI, are created in a one-to-one ratio to the primary asset, identical to the way Bitcoin is. Unlike cTokens and yTokens, where your DeFi token balance stays the same but rises in value, indicating your part of the pool, when your aToken balance increases, you are subject to income tax on the rise. You would be subject to tax on the additional units – however, there may need to be more guidance on how to account for when your balance decreases.
Earning Governance Token Taxes
A governance token is a token that grants the holder the ability to participate in the decision-making process on the future of the protocol that issued the token. These holders have the authority to make suggestions and, in certain cases, completely alter the platform’s structure of governance.
Numerous Decentralized Financing platforms such as Compound, AAVE, MStable, and MakerDAO issue governance tokens to their participants. Acquisition of these tokens is taxed depending on the manner in which they were acquired
After receiving the governance token, a person may choose to sell the token on the market for a different crypto asset or may wish to sell for USD or a stablecoin, among other options. This future sale will result in either a capital gain or a capital loss, which will be either short-term or long-term depending on how long the underlying governance token has been held in your portfolio.
Many DeFi networks are already providing governance or incentive tokens in return for engagement on their platform, becoming more popular. A significant portion of yield farming is seeking sites that provide these tokens to generate cash.
When you distribute these tokens, the tokens are taxed as income based on their current market value at the time of distribution. When you sell these tokens, you would recognize a capital gain or loss based on their value relative to the value when you received the tokens (your tax basis).
Crypto Interest Taxes
Your cost basis in the cryptocurrency is determined by the value of the crypto interest income you receive at the time of receipt. When computing your gain or loss upon disposing of the crypto, you would deduct your cost basis from the proceeds to calculate your gain or loss just as with any other trade. If you subsequently sell the cryptocurrency you’ve earned, you’ll be responsible for capital gains tax, and you’ll be required to file a tax return for that transaction. Even if you sell a cryptocurrency at a loss, you must still disclose all of your transactions.
Investment in crypto for more than one year before selling will allow you to benefit from a more advantageous long-term capital gain tax rate, which may range from 0 percent to 20%, depending on your amount of taxable income. If you sell your investment property within one year of purchasing it, you will be subject to ordinary income tax rates that may vary from 10 percent to 37 percent, depending on your tax circumstances.
Furthermore, you must report any interest you received from cryptocurrency and include it in your overall taxable income. Given the nature of crypto interest, you must record it on your income tax return as interest or other ordinary income, depending on the circumstances.
Earning crypto interest is a fantastic method to produce passive income while holding onto your cryptocurrency for the long haul. As a result of receiving interest in cryptocurrency, it becomes more important to accurately determine the Fair Market Value (FMV) and estimate the quantity of cryptocurrency you’ll need to sell to pay taxes the next year.
DeFi Platform Tax Tips
Liquidity pool tokens are a must
Many DeFi lending sites deposit interest profits straight into your cryptocurrency account. Take, for example, the scenario in which you lend Ethereum and get ETH payments in your wallet. Because lending is not regarded as an investment activity that qualifies for a capital gains tax rate, these profits are typically taxed as regular income.
On the other side, newer DeFi lending platforms offer their tokens to lenders, referred to as Liquidity Pool Tokens, or LPTs, to facilitate the lending process. As a result, these tokens are often taxed as capital gains since the process of adding or withdrawing liquidity more closely resembles a trade or token exchange rather than lending.
Tax payments in universal currency – USD
Many DeFi systems provide governance or incentive tokens to users that participate in activities on their site. In certain circumstances, these tokens account for a large chunk of the money generated by yield farming—particularly if lending yields are low—and are thus very valuable. In most cases, these tokens are taxed as ordinary income at their current market value at the time of receipt, meaning that you may owe tax even if you don’t sell them.
The worst-case scenario is that you acquire tokens through staking or farming that are worth a certain amount of money and then they become worth half their original value over a while. When it comes time to file your taxes, you will owe ordinary income tax on the initial hundred dollars in value, not the current fifty in value. The sale of tokens at a loss may help reduce your tax liability, but it’s a good idea to put aside any taxes owed in dollars at the time of distribution to avoid paying them twice. An even more worse-case scenario would be if you receive a coin through an airdrop as ordinary income and then the coin you receive drops significantly in price. After the coin drops a big amount, you have to report the income as ordinary, but if you sell the coin, you can only use $3k of losses against ordinary income, so could have a bad outcome.
Crypto taxation software is your assistant
The number of trades and transactions that cryptocurrency traders and investors make each year may vary between hundreds and hundreds of thousands. It doesn’t take long when DeFi is thrown in for things to become very complicated. DeFi crypto tax software can combine transactions across platforms and compute your yearly capital gain or loss for you as well as report any interest or other income (such as from airdrops), which is great news for crypto investors.
Gas Fees Taxes
Gas refers to the cost that must be paid to complete a transaction on the Ethereum blockchain. According to the supply and demand of the network’s miners, the fee amount is determined. Users might demand a greater charge for completing a transaction if the available computing power does not satisfy the miners’ demand.
Because the Internal Revenue Service has not released detailed guidelines on many parts of the DeFi ecosystem, including gas costs, we urge that you take a cautious approach to how you manage gas charges. However, it is likely that GAS fees would be allowed to be added to your tax basis of your coins meaning that they would reduce your capital gains upon sale of the coins.