Cryptocurrency is subject to taxes overseen by the Internal Revenue Service (IRS). The IRS issued Notice 2014-21 in 2014 stating cryptocurrency is considered ‘property’ and not currency. This essentially implies cryptocurrencies are subject to a similar tax treatment as stocks, bonds, and other assets that qualify for capital gains taxes.
So, how exactly is crypto taxed in the US? And, what defines a taxable event? This comprehensive crypto tax guide covers everything you need to need about how cryptocurrency is taxed and how to properly calculate your taxes.
Blockchains are great digital asset registries since they are secure and immutable. While cryptocurrencies have become synonymous with blockchain, the same technology can be used to store all kinds of digital items. The rise of non-fungible tokens, or NFTs, marks a step in that direction and opens the door to the digitization of many different assets.
Let’s take a closer look at non-fungible tokens, how they differ from traditional tokens, and how they will likely be treated from a tax standpoint for both creators and investors.
Learn what decentralized finance is and howyour interactions with DeFi protocols are taxed. In this guide, we coverseveral aspects of DeFi taxesincluding yield farming, the tax treatment of lending and borrowing, providingliquidity to a pool, staking, and more.
By eliminating middlemen from transactions,decentralized finance (DeFi) applications aim to provide services that aretraditionally centralized, like loans and currency exchanges, through a moreefficient, free, and decentralized platform.
Protocols like Compound, Aave, and MakerDAOallow users to lend money, earn interest and take out collateralized loans.Exchanges like Uniswap and dYdX enable users to trade crypto assets withoutusing a centralized cryptocurrency exchange.
Crypto investors are currently profiting inthe DeFi ecosystem in three important ways:
● Yield Farming + Staking
● Liquidity Pools
Crypto investors obtain DeFi tokens withoutusing regular US or foreign exchange. Decentralized exchanges do not requiretraders to go through cumbersome identity checks or open accounts in othercountries to obtain rare currencies; they just need to find an exchange thathas liquidity in the trading pair they are interested in using.
Yield farming in crypto, also known asliquidity mining, is an effort to put your crypto assets to work and generatethe most returns possible on those assets. At the simplest level, yield farmersmove assets around different DeFi protocols through their yield farmingstrategies, and work to find the best pool that is offering the best yield fromweek to week.
Several decentralized money markets exist,such as Aave, Compound, Uniswap, and others. These protocols allow you to poolcrypto assets in smart contracts, which are used as trading liquidity, or forlending to borrowers, depending on the platform. If you provide liquidity in atrading pair (ex. ETH-USDC on Uniswap) or for lending purposes (ex. DAI onAAVE) you are rewarded the fees from users who use this liquidity for tokenswaps and loans. The return on liquidity provision varies depending on demand,so yield farmers are constantly looking to move to where they can get the bestrate of return.
Another similar, but slightly different way toearn interest on your crypto assets is via staking. With staking, you lock upyour crypto assets in a smart contract, but the assets are not used forfinancial liquidity. Instead, the assets are used to secure the network byblockchains that have a Proof of Stake (PoS) consensus mechanism. As a rewardfor securing the network, you earn interest from block rewards on the saidnetwork.
Liquidity is the lifeblood of DeFi taxes, andfinance in general. In the crypto space, liquidity is known as assets that areavailable for immediate deployment (called swaps).
To understand the existence of a liquiditypool and its use, one must drill into the functionings of decentralizedexchanges. Let’s take Uniswap for example, one of the largest decentralizedexchanges on Ethereum.
Decentralized exchanges and protocols stillneed liquidity to execute trades, but using traditional methods to provide thissupply would defeat the whole premise of being decentralized. The solution isto create liquidity pools that abide by smart contracts. This liquidity pool isin place, providing liquidity to DeFi platforms (exchanges, lenders, borrowers,insurance, etc.) in a peer-to-peer fashion without the use of centralizedexchange pools that are held by a custodian.
A liquidity pool is a smart contract where thefunds from crypto users are grouped together to provide liquidity for executingtrades. Crypto holders who invest their crypto tokens into liquidity pools areknown as Liquidity Providers (LPs). Uniswap uses a smart contract to providethis liquidity using deposits made by a yield farmer, who is looking for a highrate of return in interest rates and a share of transaction fees. Assets areprovided to liquidity pools in pairs so that the tokens can be swapped betweenone another.
In exchange for providing liquidity, theseliquidity providers earn rewards from the fees users pay to use the pool. Therewards are based on their share of the liquidity pool and the swap fee. Theliquidity pools trade the cryptocurrencies (which means trading acryptocurrency with another) and crypto loans backed by collateral, in thenature of decentralization.
Uniswap is a decentralized exchange that usesautomated market-making and users' pooled assets to execute trades. Picturedabove are the three most popular liquidity pools on Uniswap.
Say someone wants to deposit $500 into theUSDC/ETH pool.
● They would start by depositing $500 worth ofUSDC, and $500 worth of ETH (approximately). BOTH assets in the pair mustalways be EQUAL to keep the liquidity balanced.
● Once those assets are in the liquidity pool,the user receives an LP token, which acts as a receipt for their deposit.
● As other users exchange their USDC for ETH, orvice versa, they are charged a 0.3% fee.
● This fee isdistributed to liquidity providers, based on their share of the pool, as areward for providing liquidity!
The market of the open pool makes it possiblefor a trading pair between Ethereum coins on Uniswap and is also highly liquiddue to its clear arbitrage opportunities.
It is also important to note that the IRS hasnot issued specific guidance for DeFi taxes, so this article bases DeFi tax treatment on existing crypto taxguidance. We will update this article as we learn more. The treatments belowrepresent the most conservative approach based on current IRS guidelinesregarding similar transactions.
At a high level, cryptocurrencies are treatedas property by the IRS and all the general rules applicable to property applyto cryptocurrency transactions. Every time you sell, spend, or exchangecryptocurrency, there is a taxable event.
As for now, all the guidance that is issued bythe IRS (Notice 2014-21, Rev. Rule2019-24, 45 FAQs) has beenquite generic and doesn’t address DeFi taxes. Nevertheless, this does not account for an excuse tonot report any of the DeFi-related taxes. There is enough guidance in place to inferthe yield farming transactions and tax implications of DeFi.
The process of yield farming and DeFigenerally includes several transactions. In the following sections, we will bebreaking down these transaction types. Some of the DeFi transactions do nothave any kind of direct or ancillary tax guidance. In addition to that, we willalso present various tax positions you can take based on your risk tolerance.
The more aggressive the tax position, thehigher its exposure. This means a greater risk of under-reporting and gettingaudited.
On the upside, considering the aggressive taxpositions would result in lower taxes, tax deferment, and lower upfront taxpayments. This means, the lower the aggressiveness level, the lesser the riskof falling into trouble with the IRS. Anyhow, you must report your incomesooner and also pay more taxes in the process.
Below, we cover the types of DeFi transactionswe commonly see, and how we treat each one for tax purposes.
1 ETH is locked into Compound, which Jimpurchased a few years ago for $50. At the time of depositing, 1 ETH is aboutworth $100. Bruce also receives about 50 cETH, a protocol token that representsthe contribution to the liquidity pool. Adding to this, the cETH is tradable atother exchanges at worth $1 per coin.
Our take: Thisis a taxable event. Jim is getting rid of his original ETH and receivingcETH, a new crypto token in a 1:1 trade. All crypto-to-crypto trades aretaxable as per the IRS (A15). Additionally, Jim gets back his collateral lateron but it's not the ETH coin he deposited. This means his original ETH has beensold in the IRS’s eyes. As a result, Jim would report $80 ($100 – $20) worth ofcapital gains from the transactions.
It can be argued that this is not taxable.Bruce is not actually selling his ETH. He is only depositing assets ascollateral. He wants to borrow funds against ETH and NOT to sell the protocoltoken, cETH.
Sometimes protocols require you to"wrap" coins before they can be deposited into a specificblockchain’s smart contract. For example, the operation of BTC is not onEthereum but on Bitcoin. Therefore, in order to use Bitcoin with DeFi-basedEthereum platforms, you need to “wrap” BTC by using the Ren protocol. Thisessentially locks the BTC in escrow for an exchange of the ERC-20 token versionof BTC, called the wBTC (Wrapped Bitcoin).
An analogy to "wrapping" in thenon-crypto world is a cashier’s check. It represents the value of dollars inyour bank and whoever gets their hands on your cashier’s check owns the rightto the underlying money in the bank.
Our take: wrappingis taxable. It could be argued that the wrapped version of the originalcoin is a new coin resulting in a sale of the original. As we said before, anycrypto-to-crypto trades are taxable.
It can also be argued that this is not a taxable sale of the BTC to receivewBTC. The intention of wrapping a coin is to add additional functionality touse BTC on the ETH blockchain. You should be prepared to defend this intent tothe IRS, however.
Let’s say Sara borrows 50 DAI that is worth$50 ($1 x $50)
Thisis likely not taxable. Otherwise,generally funds received via a loan are not taxable as they are not an incometo the borrower.
When you borrow funds from a DeFi protocol,you have to pay interest to the platform. Interest expense charged on loans isone of the main sources of income for DeFi platforms. The deductibility of thisinterest expense depends entirely on the purpose of the loan proceeds. Here aretwo plausible scenarios:
● If the funds borrowed are used to purchase a personal asset such as a new vehicle,then the interest expense is considered privatewhich is why it is not deductible.
● If you usethe funds for investing in a pool(say, for yield farming) the interest expense you incur in the process iscategorized as investment interestexpense. These come under special tax rules and are deductible only up toyour net investment earnings.
Note: Since special rules apply to investmentinterest expenses so it is important to track these separately. The amount youcan deduct each year is calculated on IRS Form 4952. Your tax professional willbe able to advise you on how to work with this situation to be accurate.
Chris receives 0.1 ETH as interest forproviding liquidity on Uniswap. At thetime of the receipt, 1 ETH is worth $200.
Thisis taxable. Receivinginterest as a reward is a taxable event where the taxes are based on thetoken’s current market value. Chris will pay based on $20 worth of Schedule 1Misc. Crypto Income for this example.
When he reports this income, the newlyreceived 0.1 ETH will now have a cost basis of $20. If Chris were to later sellthis coin on another platform for $30, he would incur a capital gain of $10 ($30– $20).
In addition to receiving more ETH interestincome, Chris also gets an airdrop of 200 Uniswap tokens. This is a taxable event and the raxes are based on the currentvalue of the token during the airdrop. Now, if Chris sells these Uniswaptokens, he will incur a capital gain or loss based on the difference betweenthe price at the time of the airdrop, and the time of the sale.
Let’s say that the price of Ethereum coinsdropped and Chris’s DeFi platform liquidated his collateral at $50.
Wesee this as a taxable event. Theliquidation of the collateral here is a disposition event, which is similar toa sale. In this case, Chris will have to pay taxes on the difference betweenhow much he originally paid for the ETH vs. the price at which the protocolliquidates it.
Thisis not taxable. Paying off aloan and getting your collateral back is not a taxable event. In the yieldfarming scenario, there is no taxable event at the time you exit the pool aslong as you recognize interest and governance token income along the way.
With that said, if you unwrap your coin when youexit the pool, that could trigger a taxable event - the guidance onthis from the IRS is less than clear. Refer to the section on wrapping.
Transaction or gas fees on sales are deductedfrom proceeds. For example, if Joan sells 1 ETH for $400 and spends $10 forgas, her total proceeds on the transaction would be $390 ($400-$10).
The Bottom Line on DeFi Guide on Taxes
Now that we’ve established what DeFi is, asyou can see, paying taxes on DeFi is a bit complicated. Luckily, ZenLedger canhelp you with your DeFi taxes,as we support over 300+ exchanges, 20+ DeFi Protocols, 3000+ tokens, allwallets, and 30+ blockchains, the most of any crypto tax software!
The crypto markets are having a volatile 2021, and that means you probably lost money on your cryptocurrencies. But, we have good news! There is a smart tax strategy called crypto tax-loss harvesting that will help you reduce your losses and your tax burden.
Since cryptocurrency is treated as “property” under IRS rules, that means the same capital gains rules apply to taxes on cryptocurrency gains. So if you had losses from your crypto investments in 2022, make sure to read this crypto tax guide to save up to $3,000 on your income taxes.
Do some of your clients own crypto? Do they have to explain to you what cryptocurrency is? Would you like to improve your expertise in the area of crypto taxation? If you answered yes to any of these questions, this crypto tax guide is for you!
Learn everything you need to know about how to help your clients prepare and file their crypto taxes with our guide.