The crypto market tends to go through waves of innovation. After the initial rise of Bitcoin, Ethereum sparked a wave of altcoins that came to market through initial coin offerings, or ICOs. Unfortunately, a combination of high-profile fraud and regulatory actions cooled the market, but the growth spawned more legitimate offerings in the aftermath.
Decentralized finance, or DeFi, has become one of the hottest parts of the crypto market. According to DeFi Pulse, DeFi protocols like Aave, Maker, and Compound have more than $90 billion locked up, making them a force in the financial industry. These protocols span lending, decentralized exchanges, derivatives, payments, and asset management platforms.
Let's explore the concept of decentralized finance, the role of rewards, and how taxes on crypto rewards work.
What is Decentralized Finance?
Decentralized finance, or DeFi, is a term that encompasses all financial services on the blockchain, including borrowing, lending, insuring, trading, and more. Leveraging the power of the blockchain, these financial transactions are faster and don't require paperwork or third-party intermediaries. It's also pseudo-anonymous and open to everyone.
The three most popular DeFi protocols are:
- Aave is an open-source non-custodial protocol on Ethereum for decentralized lending and borrowing.
- Maker is a decentralized credit platform on Ethereum that supports Dai, a stablecoin pegged to the U.S. dollar.
- InstaDApp is a smart wallet with an intuitive interface built on top of popular DeFi platforms for managing assets.
While these three protocols focus on lending, decentralized exchanges, or DEXs, are another fast-growing market subset. For example, Curve Finance is a DEX liquidity pool designed to support efficient stablecoin trading activity. The goal is to facilitate trades with low slippage and a low fee algorithm specially designed for stablecoins.
Other subsets of the DeFi market include payments, assets, and derivatives. For instance, Flexa is an instant, fraud-proof payments network for digital assets that enables anyone to spend a variety of cryptocurrencies instantly, privately, and with zero fees at multinational brands across the United States and Canada. And more use cases arise every year.
Taxes on Crypto Rewards
The IRS has made it abundantly clear that cryptocurrency transactions are subject to taxation. Notice 2014-21 states that cryptocurrencies are property and subject to income and capital gains taxes. Like stocks, any dividends or interest are taxed as ordinary income, while any increase in value is a short- or long-term capital gain.
Many DeFi platforms use rewards to incentivize users. For example, suppose that you stake $10,000 of USDC to AAVE and receive $10,000 in aUSDC in return. If AAVE offers a 2.95% interest rate, you will receive $295 worth of aUSDC as an interest payment. You could then sell or exchange the aUSDC or continue to hold it over time.
From an investment standpoint, these dynamics are similar to conventional lending whereby a lender will loan an asset to a borrower in exchange for interest payments and the eventual return of the principal. The difference is that the blockchain enables these transactions to occur peer-to-peer and without the use of a financial intermediary.
Similar to interest income, there are usually taxes on DeFi at ordinary income rates. So in the example above, you would owe regular income tax on the $295 worth of income when you receive it. If aUSDC declined in value, you would still owe income tax on the $295. If you sold aUSDC for USD, you would owe capital gains taxes on any increase in value.
DeFi Tax Nuances & Exceptions
DeFi platforms are constantly evolving, which could impact taxes on DeFi transactions. For instance, suppose that you lend 10,000 DAI to COMP and receive $10,000 worth of cDAI in return. If COMP offers a 2.95% interest rate, the value of your cDAI will increase by $295. You would then owe capital gains tax after selling or exchanging the cDAI.
The minting of interest-bearing tokens is another grey area of the law. Suppose you mint aTokens or cTokens or transfer into or out of liquidity pools. In that case, you may realize capital gains on the underlying assets minted into tokens since they're crypto-to-crypto trades. On the other hand, some tax experts consider these non-taxable migrations.
Another common scenario is receiving a DeFi reward that falls in value. In that case, you would owe income tax on the original amount—establishing a new cost basis—and potentially write-off the decrease in value from the cost basis. The IRS lets you offset all of your capital gains across different asset classes along with up to $3,000 of ordinary income.
It’s important to remember that the DeFi tax law is fluid and constantly changing. Since the IRS hasn’t given much definitive guidance, investors should work with tax professionals to ensure that their interpretation is defensible. It’s also a good idea to keep an eye out for any additional tax guidance or clarifications from regulatory authorities.
Tracking DeFi Tax Obligations
A common challenge for DeFi investors is tracking their liabilities arising from taxes on crypto rewards. While looking up past cryptocurrency transactions is pretty straightforward, tracking past reward tokens is far more complex. As a result, investors must keep diligent records to ensure that they comply with IRS taxes—particularly for audit defense.
One way to simplify tax reporting is to use a single platform. For instance, Coinbase Wallet enables users to lend their crypto and earn interest on DeFi protocols. Since everything is in one wallet, it's much easier to access a transaction record and ensure that you have all the data you need to complete your taxes each year.
ZenLedger makes it easy to connect your wallets and exchanges to track DeFi transactions automatically. That way, you don't have to worry about keeping separate records or paying accountants to go through a mountain of paperwork. Instead, you can click a button and prepopulate the tax forms you need each year or even integrate with TurboTax. Try it for free!
How to File Your Taxes
Most DeFi transactions fall under hobby or business income. In most cases, business income is subject to higher tax rates since you must pay Social Security and Medicare taxes on top of conventional income taxes on crypto rewards. While it’s tempting to classify everything as hobby income, the IRS is very diligent in ensuring that you’re paying the appropriate taxes.
There are some important differences between the two classifications:
- Business Income: The IRS considers you a business if you invest a substantial amount of time with the goal to boost profits and depend on the income for your livelihood. Business income is typically reported under Form 1040 Section C and may trigger self-employment taxes, although you can deduct your expenses.
- Hobby Income: The IRS considers hobby income to be income that arises from small investments and modest earnings. If that’s the case, you will typically file taxes under the “Additional Income” section of Form 1040. If you earn more than $400 per year, you may need to file income under Schedule SE and pay additional taxes.
Investors that report business income can deduct certain expenses. For example, they may be able to deduct educational expenses or subscriptions, the cost of dedicated computer equipment, and even things like office space as long as it’s not used for anything else. Talk with your accountant to maximize deductions in a way that minimizes audit risks.
The Bottom Line
Decentralized finance has become tremendously popular, with more than $90 billion locked up over the past few years. However, investors that use these protocols to earn interest should keep taxes on crypto rewards in mind. Fortunately, ZenLedger and other crypto tax software make it easy to automate the process and create the paper trail you need.