DeFi Taxes 2021: How to Pay Tax on Borrowing, Lending, Yield Farming, and Liquidity Pool Funds

Key Takeaways

• Capital gains tax and income tax apply to DeFi earnings depending on the activities and platforms in question.

• Liquidity pool tokens are typically subject to capital gains, while native tokens are more commonly subject to ordinary income tax.

• You can take out a crypto loan to pay taxes without triggering another tax event by selling crypto -- just be careful of margin calls.

Taxes are one of the more opaque issues in crypto, with many investors still unsure how to calculate taxes on earnings or whether they owe taxes at all. The DeFi space, in particular, has many moving parts when it comes to taxation and asset classes.

Crypto Briefing has put together a brief guide that lays out how users DeFi income might be taxed, as well as ways they can save money come tax season.

DeFi Taxes Ordinary Income vs. Capital Gains

Users will need to pay either capital gains tax or ordinary income tax on any profits from loaning crypto on DeFi platforms. Check the DeFi platforms documentation to see whether capital gains or income tax applies.

Platforms paying crypto directly to users wallet balance are generating ordinary income for their users. If users loan BTC and receive BTC in return, users will likely be taxed as they would on their salary or other ordinary income, and marginal tax rates apply. The tax applies to the market value of crypto at the time a user receives it.

However, when a platform pays out in its own liquidity pool token (LPT), profits from selling that LPT usually fall under capital gains tax. Capital gains tax applies to all property, including crypto, which is also classed as property. This can be cheaper in some cases, particularly when the asset is held for over a year and cheaper capital gains rates apply.

If a user earns crypto as ordinary income and sells that crypto after it has risen in value, they may need to pay both income tax and capital gains tax.

When users supply liquidity to a DeFi pool with crypto assets and withdraw those assets in exchange for their LPT reward, users incur capital gains at the point of withdrawal.

Example

Examples of LPTs from two major DeFi lending platforms, Compound and Aave, may provide more clarity.

Aave issues its interest-bearing aTokens at a 1:1 ratio with the underlying asset that users supply. So if users supply 100 DAI, they‘ll receive 100 aDAI. If users supply 10 ETH, they’ll receive 10 aETH. Aave‘s aTokens are taxed as ordinary income — when the aToken balance increases, they’re liable for income tax on that balance.

Taxable events here include:

• Users incur capital gains tax on the ETH when originally exchanging it for aETH.

• If users earn more aETH, they are liable for ordinary income tax on those earnings.

• When users sell or burn aETH, they once again recognize capital gains or losses based on whether the price of the underlying asset, ETH, has moved.

Note: Capital losses do not offset ordinary income tax, so if users sell aETH for a capital loss, this is not deductible from the ordinary income tax bill.

Compound, on the other hand, does not issue cTokens at a 1:1 ratio. When a market earns interest, cTokens are worth an increasingly larger sum of the underlying asset — their balance of cTokens does not increase, but rather the value of those cTokens increases. This is taxable as capital gains tax rather than ordinary income.

COMP, on the other hand, the native Compound token, is issued as part of its governance incentives and other incentives. When a DeFi platform distributes its native token as a reward, it is usually taxed as ordinary income. This applies to COMP, BAL, YFI, and other native DeFi tokens.

How to Save Money Through DeFi Taxes

DeFi users can take out crypto loans to save money on taxes.

When they borrow crypto for collateral, they are not generating a taxable event. Many DeFi users take out loans such as supplying ETH collateral to borrow funds to pay taxes without triggering more taxable events.

Its important to note that if the value of the collateral (in the above case, ETH) sinks too low, then a margin call or liquidation will be triggered. The IRS will treat this as if a user had sold the funds, generating another capital gains or losses event.

How to File DeFi Taxes

It is recommended to consult a professional crypto tax specialist when it comes to filing DeFi taxes. CryptoTrader.Tax, TaxBit, and TokenTax are three examples of tax firms experienced in cryptocurrency taxation, using specialized crypto tax software to calculate users final returns.

Its always a good idea to maintain good record-keeping throughout DeFi and crypto trading and investing to make tax season as seamless as possible, leaving users with more time to focus on the opportunities that lie ahead.