The Comprehensive Guide to DeFi Taxes (2023)

DeFi is here to stay. Right now, it’s estimated that there’s more than eighty billion dollars locked up across all DeFi protocols. 

With this flurry of DeFi activity comes the fated question: What are the tax implications for DeFi? How can investors report DeFi transactions on their tax returns? 

In this article, we dive into these questions and explore how common DeFi transactions are taxed including lending, borrowing, yield farming, liquidity pools, and earning. We’ll also cover the tax implications of some of the most popular DeFi protocols. 

CoinLedger serves more than 250,000 investors worldwide, and our team of tax experts carefully tracks the latest developments in tax policy. We’ll continue to update this guide as more regulatory updates are released. 

Crypto taxes 101

In the U.S. and many other countries, cryptocurrencies are treated as property for tax purposes. That means if you’re interacting with DeFi protocols, you may incur capital gains and income tax liability. 

Capital gains: When you sell, exchange, or otherwise dispose of your cryptocurrency, you incur capital gains or capital losses depending on how the price of your crypto has changed since you originally received it. 

Ordinary income: When you earn cryptocurrency through any means whether that is mining, staking, or various forms of interest, you recognize income based on the fair market value of the cryptocurrency at the time it is received. 

If you’re not aware of the tax implications of crypto, we recommend starting out with our article: The Complete Guide To Cryptocurrency Taxes.

How is DeFi taxed? 

While the IRS has not released any direct guidance on DeFi specifically, they have released general guidance on cryptocurrency. The tax implications for DeFi can be inferred from these guidelines as well as previous legal doctrines. 

What is decentralized finance (DeFi)?

DeFi, short for decentralized finance, is an area of cryptocurrency focused on enabling access to financial services such as trading, lending, and borrowing without incurring the costs or delays associated with traditional rent-seeking middlemen (i.e. banks, financial institutions, etc).

While many popular DeFi applications are on the Ethereum ecosystem, others exist on chains such as Solana and Avalanche. Some unique technological advancements such as Automated Market Making (AMM) and Liquidity Pools enable the “decentralized” capabilities of many of the most popular DeFi platforms today. 

These new advancements create some unique tax situations which we address below.

Do DeFi protocols report to the IRS? 

At this time, most DeFi protocols do not report to the IRS. However, this could change in the near future. 

The infrastructure bill, signed by President Biden in November 2021, requires that any party that facilitates a cryptocurrency transaction provide 1099 tax reporting information to the user and the IRS. 

At this point, it’s not clear whether these requirements will apply to DeFi protocols who, as it stands today, might not have the capability to send 1099s. After all, since these protocols are decentralized, there’s no party that has the capability to do proper reporting. It’s possible that this bill could have a huge impact on how the DeFi ecosystem operates in the United States. 

However, the crypto provisions of the bill do not go into effect until January 2024. Until then, it’s widely expected that prominent crypto companies will lobby against the bill in the courts. 

DeFi lending and liquidity pool taxes

When you lend your cryptocurrency out, you are liable to pay taxes on any income that you receive as a result of your lending activity. As noted earlier, profits from this activity will likely be taxed as capital gains or ordinary income depending on the specific nature of your transactions. 

Example: How common DeFi transactions are taxed 

Here’s an example of an interaction with a DeFi protocol where the user recognizes capital gains, capital losses, and ordinary income. 

In summary, Lucas first recognizes a $100 capital gain, then $30 of ordinary income, and then a $100 capital loss. Because Lucas’s capital loss nets against his capital gain, he has $0 of capital gain and only recognizes $30 of ordinary income. 

As you can see, DeFi transactions can get complicated very quickly from a tax reporting perspective. That’s why we recommend using cryptocurrency tax software like CoinLedger that can connect to blockchains like Ethereum and help you easily track all of your taxable events.

Yield farming and liquidity mining taxes

Advancements in the way decentralized exchanges enable crypto-to-crypto trading (via automated market making and liquidity pools) has brought on a wave of new cryptocurrency activity focused on earning yield. 

“Liquidity Providers” seek to earn rewards by providing liquidity for different trading pairs. Many of these protocols give liquidity providers tokens that they can use to claim their pooled assets at any point in time. 

The IRS has not released any guidance about providing liquidity to liquidity pools. As a result, some investors choose a conservative approach to tax reporting, while others choose a more aggressive approach. 

Conservative approach: Treat exchanging cryptocurrency for LP tokens as a crypto-to-crypto exchange. You’ll incur capital gains or losses depending on how your crypto has changed since you originally received it. 

Aggressive approach: Treat exchanging cryptocurrency for LP tokens as equivalent to a deposit, which is considered a non-taxable event. This stance argues that true tax ownership is not transferred upon creation of LP tokens.

DeFi rewards taxes: governance and incentive tokens

In recent years, governance tokens have become more common. They are  used to incentivize cryptocurrency holders to use their assets as collateral to allow “Yield Farmers” to ramp up their potential earnings.

The concept of governance tokens was popularized by Compound’s COMP. COMP is distributed to anyone who supplies or borrows crypto to/from Compound.

You recognize ordinary income when you receive governance and incentive tokens similar to COMP. The amount of income you recognize is equal to the market value of COMP (or other governance token) at the time it is received. 

Additionally, when you sell your COMP (or related governance token), you trigger a taxable event and recognize a capital gain or capital loss depending on how your COMP has changed in value since you originally received it.

How are wrapped tokens taxed? 

Some investors ‘wrap’ their existing coins to interact with DeFi protocols. For example, investors may wrap their Bitcoin to interact with protocols built on the Ethereum blockchain. 

Since the IRS has not yet ruled on the issue of wrapped tokens, it is considered a gray area in the tax code. As a result, some investors choose a conservative approach to reporting these transactions, while others choose a more aggressive approach. 

Conservative approach: Treat the act of wrapping your coins  as a crypto-to-crypto exchange. You’ll incur capital gains or losses depending on how the price of your tokens has changed since you originally received them. 

Aggressive approach: Treat the act of wrapping your coins as equivalent to holding the same cryptocurrency. In this case, wrapping would be considered a non-taxable event. 

For more information, check out our complete guide to how wrapped/bridged tokens are taxed. 

Borrowing / taking out a crypto loan

So far we have focused on the tax implications for one side of the market, the lender. But what if you are the borrower? What are the tax implications of taking out a loan?

In general, taking out a loan is not considered a taxable event. Therefore, it’s reasonable to assume that crypto loans will be treated the same way. 

However, some DeFi loan providers require executing a swap in order to take out the loan. For example, taking out a loan on Ethereum in Compound requires you to exchange ETH for cETH. It’s unclear whether this will be considered a taxable event like other crypto-to-crypto transactions. 

The conservative approach would be to report this type of loan as a taxable event and incur capital gains or losses depending on how the price of your collateral has changed since you originally received it. 

The aggressive approach would be to consider the deposit of collateral as a transaction that does not transfer tax ownership to the custodian. This would be treated as non-taxable. 

Are crypto loan interest payments tax deductible?

The IRS has yet to issue specific guidance surrounding interest payments in crypto lending. However, you can get a better idea for how they may be treated by looking at traditional lending. To understand whether your interest payments are tax-deductible, it is necessary to consider whether a loan is used for personal, investment, or business-related purposes.

If a business takes out a loan for a commercial purpose, the interest is treated as a legitimate tax-deductible business expense.

If a loan is taken out for personal reasons, interest expense is typically not considered tax-deductible. This is the case if you’re taking out the loan to pay off credit cards, or even to pay your tax bill.

If you use the borrowed funds for investment purposes (for example, yield farming or purchasing/trading coins) the interest expense you incur is classified as investment interest expense. Investment interest expenses are subject to special tax rules and are deductible only up to your net investment income. 

‍For more information, check out our complete guide to how cryptocurrency loans are taxed. 
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