The crypto ecosystem continues to evolve at a breakneck pace, but tax rules and regulations have been slow to catch up. While buying and selling Bitcoin or Ethereum is straightforward, there’s far less certainty surrounding the tax treatment of active trading, staking, and yield farming. So, if you’re engaged in these activities, you may face some tough decisions.
This guide looks at how the IRS treats digital assets, particularly how tax rules vary for trading, staking, and yield farming.
How the IRS Treats Crypto
The IRS treats digital assets – including cryptocurrencies, stablecoins, and non-fungible tokens (NFTs) – as property. When you receive, sell, or exchange these assets, you’re typically on the hook for ordinary income or capital gains taxes.
Some not-so-obvious taxable transactions include:
- Receipt of a digital asset as payment for goods or services.
- Receipt of a new digital asset from mining or staking activities.
- Receipt of a new digital asset due to a hard fork.
- Receipt of a digital asset as the result of an airdrop.
- Any other disposition of a financial interest in a digital asset.
Ordinary Income vs. Capital Gains
Cryptocurrency transactions typically fall into one of two buckets. If you receive crypto as interest, the entire amount is taxable at ordinary income tax rates. On the other hand, if you’re disposing of your crypto, the net gain will be taxed as capital gains. And you’ll pay the higher short-term capital gains tax rate if you held the digital asset for less than a year.
The differences between short-term and long-term capital gains can be substantial. For example, here’s the 2023 ordinary income (short-term capital gains) tax table:
|Tax Rate||For Single Filers||For Married Individuals Filing Joint Returns||For Heads of Households|
|10%||$0 to $11,000||$0 to $22,000||$0 to $15,700|
|12%||$11,000 to $44,725||$22,000 to $89,450||$15,700 to $59,850|
|22%||$44,725 to $95,375||$89,450 to $190,750||$59,850 to $95,350|
|24%||$95,375 to $182,100||$190,750 to $364,200||$95,350 to $182,100|
|32%||$182,100 to $231,250||$364,200 to $462,500||$182,100 to $231,250|
|35%||$231,250 to $578,125||$462,500 to $693,750||$231,250 to $578,100|
|37%||$578,125 or more||$693,750 or more||$578,100 or more|
For comparison, here’s the long-term capital gains tax table:
|For Single Filers||For Married Individuals Filing Joint Returns||For Heads of Households|
As you can see, a person earning $250,000 per year would pay a top tax rate of 35% for short-term capital gains compared to 15% for long-term capital gains – a 20% difference!
When computing your capital gain, you must first determine your cost basis. For example, if you sold BTC to buy ETH, the cost basis for your ETH would be the U.S. dollar value of the BTC when you sold it. These calculations can become even more complex if you have multiple transactions since you must decide which BTC to use when calculating your cost basis (e.g., the last BTC, first BTC, or some specific BTC purchase in the past).
Then, your capital gain is the difference between your total sale proceeds and your cost basis, less transaction costs.
Trading vs. Staking vs. Farming
Most digital asset trading activity generates capital gain-generating transactions. That’s because you’re typically buying crypto assets (generating no taxable transaction) and then selling them to realize a profit (generating a capital gain if you have a net gain). If you experience a net loss, you can use it to offset other capital gains or up to $2,000 in ordinary income. And if you can’t use it in the current year, you can roll it forward to future years.
The IRS treatment of staking is a little less clear. If you receive staking rewards, they’re typically taxable as ordinary income equal to the value of the coins when you receive them. However, if these rewards are locked up – such as in the case of Ethereum 2.0 – you could argue to defer your taxable income until the funds are available. Whether to argue depends on how much you have at stake and your willingness to undergo an audit.
Yield farming is a little more ambiguous because the specifics vary between decentralized finance (DeFi) platforms. When using these platforms, you should consider the potential tax consequences carefully to avoid unexpected tax bills.
For example, suppose you exchange a cryptocurrency you own for an underlying liquidity pool token that appreciates until you exchange it back. In this scenario, you could owe capital gains tax on the initial cryptocurrency disposal and ordinary income tax on the value of the LP tokens you receive – a potentially large tax bill!
Some key points to remember include:
- Wrapped Tokens – Many DeFi protocols require you to wrap tokens to transfer them across blockchains, which could trigger unexpected taxable events. While the IRS hasn’t provided specific guidance, they will likely consider the wrapped version of the original token a new token, resulting in the sale of the original token. Moreover, unwrapping the token could trigger another taxable event.
- Governance Tokens – Some DeFi platforms airdrop governance tokens to participants, enabling them to vote on the protocol’s future development. Since these tokens have value, they’re taxable when you receive the airdrop as ordinary income – even if you don’t sell them. However, you could claim a deduction if you sell them at a loss.
While treating liquidity pools and wrapped tokens as crypto-to-crypto transactions is conservative, you could argue that these are non-taxable events. For example, you could argue that wrapping a coin is equivalent to holding the same cryptocurrency or exchanging a coin for an LP token is equivalent to a deposit. And as a result, these shouldn’t be considered taxable events.
Tips to Reduce Your Taxes
The IRS may seem overzealous in assessing taxes on digital assets, but fortunately, there are several ways to (legally) lower your tax bill.
Some of the best strategies include:
- Deduct Fees – Trading, staking, and yield farming often involve various fees, including gas and transaction fees. You can deduct these fees from your overall gain (or add them to your losses) to reduce your taxable gains.
- Use an IRA – Most individual retirement accounts (IRAs) don’t let you buy and sell crypto assets, but self-directed IRAs (SDIRAs) offer more flexibility. If you trade, stake, or yield farm in SDIRAs, you can let the income and profits grow tax-free (Roth) or take deductions immediately to offset them (Traditional).
- Harvest Tax Losses – Tax loss harvesting involves selling an asset to realize a loss and then replacing the asset in your portfolio. Since crypto assets aren’t subject to the Wash Sale Rule, you can harvest tax losses to offset your capital gains.
- Obtain a Loan – Consider taking out loans against your crypto assets rather than selling them. While you may owe interest, loans aren’t a taxable event, and you may be able to save more on capital gains taxes than you pay in interest.
In addition to reducing your tax liabilities, crypto tax software can help accurately compute what you owe to avoid underpaying or overpaying taxes. For example, ZenLedger automatically aggregates transactions across your wallets and exchanges, calculates your capital gain or loss, and generates the tax forms you must file. That way, you don’t have to worry about fines for underpaying taxes or accidentally overpaying them.
The Bottom Line
The IRS provides guidance on the tax treatment of many crypto transactions, but some edge cases can be confusing. For example, DeFi protocols introduce some ambiguity where you could take a conservative or aggressive approach. However, it’s worth remembering that aggressive strategies could trigger an IRS audit, creating more problems than it’s worth, depending on your tax liability.
ZenLedger can help you overcome ambiguity by automatically addressing these questions conservatively. And if you choose to take an aggressive approach with the help of an accountant, the platform offers a grand unified accounting spreadsheet that you can use to match up transactions and support your decision.
This material has been prepared for informational purposes only and should not be interpreted as professional advice. Please seek independent legal, financial, tax, or other advice specific to your particular situation.