Decentralized finance, or DeFi, has become increasingly popular among both consumers and investors. By eliminating the middleman, these services make it possible to borrow, lend, and trade in less time and with less cost. These opportunities are constantly expanding as crypto continues to encroach on conventional financial services.
The DeFi revolution enables crypto traders and investors to generate an attractive yield on their crypto assets—a key investment objection to holding crypto assets in the past. Of course, there are tax consequences that play a role in the profitability of these lending activities. The good news is that there are ways that you can keep these liabilities in check.
Let’s take a look at the basics of DeFi crypto tax and the five must-know tax tips that can help you reduce your tax liability.
DeFi Crypto Taxes 101
DeFi, short for decentralized finance, is an area of cryptocurrency focused on enabling access to financial services such as trading, lending, and borrowing without delays or extra prices incurred by a middleman like with traditional financial institutions. It also utilizes automated market-making (AMM) and liquidity pools in order to provide decentralized trading.
DeFi Lending & Liquidity Pool Taxes
When you lend your cryptocurrency out or contribute it to a platform that supplies loans to crypto, you are liable to pay taxes on any income that you receive as a result of your lending activity.
Your earning as a result of your lending activity can take one of two forms. Depending on the DeFi platform you use, your income will either be:
- Ordinary income (e.g. income received from a salary), or
- Capital gains income
It is important to understand the distinction between ordinary income and capital gain income because they have different tax implications.
Ordinary Income vs. Capital Gains
Ordinary income is taxed at your marginal tax bracket.
- Lending platforms pay earnings from interest directly to your crypto balances. This means that for lending ETH, you’d earn ETH and see your wallet balance increase accordingly.
- If you’re earning crypto tokens for lending (i.e. your balance increases when you earn interest income), then you’ll recognize this as ordinary income (like income earned as payment/salary).
Capital gains income on the contrary has significant tax savings benefits.
- Newer DeFi platforms have issued their own tokens, also known as Liquidity Pool Tokens (LPTs), where this income may be recognized as capital gains.
- Adding or removing liquidity is structured like a trade or token swap. In such cases with cTokens, the value of your LPTs increases — but the quantity in your ETH wallet remains the same.
- When you convert your cTokens to the original asset, the cost basis of your cTokens is compared to the amount of the original asset you receive in return to calculate your gain from interest collected by the pool.
5 Must-Know Tips To Reduce DeFi Tax Liability
#1. Use Liquidity Pool Tokens (LPTs)
Many DeFi lending platforms pay earnings from interest directly to your crypto balance. For instance, you might lend ETH and receive ETH payments in your wallet. These earnings are usually taxed as ordinary income (e.g., the highest tax rate) since lending isn’t considered to be an investment activity that qualifies for a capital gains tax rate.
On the other hand, newer DeFi lending platforms issue their own tokens, called Liquidity Pool Tokens, or LPTs, to lenders. These tokens are usually taxed as capital gains (e.g., the lower tax rate) since adding or removing liquidity is structured like a trade or token swap rather than lending, which is considered an investment activity.
Tax tip: Use DeFi lending platforms with LPTs to reduce your tax rate.
#2. Set Aside Tax Payments in Dollars
Many DeFi platforms distribute governance or incentive tokens for activity on their platform. In some cases, these tokens represent a significant portion of the income from yield farming—especially if lending yields are low. These tokens are usually taxed as ordinary income at their current market value, which means you owe tax even if you don’t sell them.
The worst-case scenario is that you receive tokens worth $100 and they fall to $50 in value. At tax time, you owe ordinary income tax on the original $100 in value and not the $50 in current value. You can offset some of that tax exposure by selling the tokens at a loss, but it’s a good idea to set aside taxes that you owe in dollars at the time you receive the distributions.
Tax tip: Set dollars aside to pay taxes on any distributions to avoid surprises.
#3. Harvest Tax Losses Before December
Tax-loss harvesting is the process of selling crypto assets at a loss to offset capital gains tax liability. While the wash sale rule makes tax-loss harvesting difficult in equity markets, DeFi crypto tax-loss harvesting rules are relatively forgiving—you can sell and repurchase the same crypto asset at will in order to realize the loss in the current year.
If you’re sitting on a large gain from DeFi lending, you may want to consider selling long-term crypto assets in your portfolio that are in the red. You can fully offset any capital gains with these losses and even offset up to $3,000 in ordinary income per year. You can even use tax-loss harvesting tools to automatically find opportunities in your portfolio.
Tax tip: Harvest tax losses before December 31 to lower your taxes.
#4. Keep Track of Your Gas Fees
Most DeFi platforms operate on the Ethereum blockchain, which means that transactions are subject to gas fees—or fees to compensate users for the computing energy required to validate transactions on the blockchain. These fees are often passed on to DeFi users, especially as yield farming becomes increasingly popular.
While gas fees cut into profit margins, they are deductible from the proceeds of any sale and can lower your taxable income. If you sell 1 ETH for $600 and pay $5 in gas fees, the total taxable proceeds from the transaction would be just $595. You wouldn’t owe tax on the $5 in gas fees for the transaction—and those savings add up over time.
Tax tip: Keep track of your gas fees to reduce your taxable income.
#5. Use DeFi Crypto Tax Software
Crypto traders and investors might make hundreds or thousands of trades each year. When DeFi is added into the mix, their tax situations quickly become very complex. The good news is that DeFi crypto tax software can help you automatically aggregate transactions across exchanges and calculate your capital gain or loss for the year.
ZenLedger provides one of the most comprehensive DeFi crypto tax solutions on the market. In addition to aggregating transactions and computing taxes, the platform integrates with TurboTax to make filing seamless. The transparent process of calculating tax liability also means that you can easily defend yourself in the event of an audit.
Tax tip: Use DeFi crypto tax software to ensure that your taxes are accurate.
The Bottom Line
DeFi platforms have become an increasingly popular way to generate a yield from crypto assets, but they also come with a wide range of tax implications. By keeping the aforementioned tips in mind, you can reduce your tax liability and ensure that you’re not overpaying taxes. If you’re interested in a crypto tax solution to help, try ZenLedger today!