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

The central theses

• DeFi earnings are subject to capital gains tax and income tax, depending on the activities and platforms involved.
• Liquidity pool tokens are typically subject to capital gains, while native tokens are more often subject to normal income tax.
• You can borrow crypto to pay taxes without triggering another tax event by selling crypto – but be careful with margin calls.

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Taxes are one of the more opaque topics in crypto, as many investors are still unsure how to calculate profit taxes or if they owe taxes at all. The DeFi space in particular has many moving aspects when it comes to taxes and asset classes.

Crypto Briefing has put together a short guide outlining how users’ DeFi income can be taxed Ways to save money during tax season.

DeFi taxes ordinary income versus capital gains

Users must pay either capital gains tax or ordinary income tax on profits from cryptocurrency lending on DeFi platforms. Check the DeFi platform documentation to see if capital gains tax or income tax applies.

Platforms that pay crypto directly to users’ wallet balances generate regular income for their users. If users borrow BTC and receive BTC in return, users are likely to be taxed like their salary or other taxes ordinary incomeMarginal tax rates apply. The tax applies to the market value of the cryptocurrency at the time the user receives it.

However, when a platform pays out in its own Liquidity Pool Token (LPT), profits from selling that LPT typically fall below that capital gains tax. Capital gains tax applies to all real estate, including cryptocurrencies, which are also considered real estate. This may be more favorable in some cases, particularly where the asset is held for more than one year and more favorable capital yield rates apply.

If a user earns cryptocurrencies as ordinary income and sells those cryptocurrencies after their value has increased, they may have to pay both income tax and capital gains tax.

When users provide liquidity with crypto assets to a DeFi pool and withdraw those assets in exchange for their LPT reward, users make capital gains at the time 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 to the base value provided by users. So if users provide 100 DAI, they will get 100 aDAI. If users pledge 10 ETH, they will receive 10 aETH. Aave’s aTokens are taxed as ordinary income – if the aToken balance increases, they are subject to income tax on that balance.

Chargeable events include:

• Users will pay capital gains tax on ETH when they originally convert it to aETH.
• As users earn more aETH, they are subject to normal income tax on that income.
• In turn, when users sell or destroy aETH, they recognize capital gains or losses based on whether the price of the underlying asset ETH has changed.

Note: Capital losses are not offset against normal income taxSo if users sell aETH with a capital loss, it is not deductible from the normal income tax bill.

Compound, on the other hand, does not issue cTokens in a 1:1 ratio. As a market earns interest, cTokens are worth an ever-increasing value of the underlying asset – your holding of cTokens does not increase, but the value of those cTokens increases. This is taxable as capital gains tax and not ordinary income.

COMP, on the other hand, the native compound token, will be 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 with DeFi taxes

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

If they are lending crypto as collateral, they will not generate a taxable event. Many DeFi users borrow, for example by posting ETH collateral to borrow funds to pay taxes without triggering further taxable events.

It is important to note that if the value of the collateral (ETH in the above case) drops too much, a margin call or liquidation will be triggered. The IRS will treat this as if a user had sold the fundscreating another capital gain or loss event.

How to submit DeFi taxes

It is recommended to consult one professional crypto tax specialist when it comes to filing DeFi taxes. CryptoTrader.Tax, TaxBitAnd token tax are three examples of tax firms that have experience in taxing cryptocurrencies and use specialized tax firms Crypto Control Software to calculate users’ final returns.

It is always a good idea to keep good records throughout DeFi and crypto trading and investing to make tax season as smooth as possible and give users more time to focus on the opportunities ahead.

Disclosure: At the time of writing this article, the author held Bitcoin.

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Disclosure: If you use any of the above tax services links mentioned in this article, you are supporting independent journalism on Crypto Briefing. This does not affect our reporting. We continue to pursue a fair and balanced editorial team. For more information about our partnership with Sorare, please contact us via Twitter or Telegram.

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