How is DeFi taxed?

Defi

What is DeFi?

If you’ve heard the words “DeFi” floating around, you may wonder what it is and how it relates to cryptocurrency. DeFi stands for decentralized finance, a type of financial service or application that uses blockchain technology and cryptocurrencies to remove third-party intermediaries like banks and other financial institutions from the equation.

The point of DeFi is to make financial services faster, cheaper, and more accessible by removing traditional barriers such as high fees or slow transaction times. By using smart contracts on public blockchains like Ethereum and Tron, users can access loan services, trading platforms, insurance products, liquidity pools, yield farming opportunities, and more without needing to deal with an intermediary. All these features are available in an open-source environment where no single entity controls the system or its data.

How is DeFi taxed?

When it comes to taxation, every country has its own set of rules when it comes to taxing cryptocurrency activities. Generally speaking, income generated through DeFi activities, such as interest on deposits or fees collected from providing liquidity, are subject to taxation depending on the jurisdiction where they take place. Taxpayers need to be aware that certain countries may only recognize cryptocurrencies as capital assets instead of currency for tax purposes. This means that any profits made from trading or investing in cryptocurrencies will be subject to capital gains taxes.

Most Popular DeFi Protocols and Their Tax Treatment

  1. Uniswap V2

    Exchanging one digital asset for another on Uniswap is a taxable transaction that results in capital gains or losses based on the varying prices of the coins since you got them.

    When you invest in a liquidity pool, you receive liquidity pool tokens that represent your stake. This also results in a taxable event, with capital gains or losses.

    As the pool’s interest grows, the value of UNI liquidity pool coins rises. You return the UNI liquidity pool tokens and book any capital gains or losses when you depart the liquidity pool.

  2. Uniswap V3

    Converting a liquid asset into a Non-Fungible Token (NFT) is a taxable event.

    When the pool earns interest, the value of your NFT rises. When you exit the liquidity pool and exchange your NFT for an underlying position, you will register capital gains or losses based on the NFT’s price.

  3. Compound

    Swapping your Ethereum for cETH is taxable since you dispose of Ethereum while exchanging it for cETH.

    Earning COMP tokens as a reward for using the platform will also be considered taxable income.

  4. Maker

    Trading cryptocurrencies on Maker is a taxable event.

    Your earned DAI tokens for using the platform and participating in events are also subject to taxes.

  5. Balancer

    Exchanging one digital asset for another on Balancer is a taxable occurrence, requiring payment to the government.

    Joining or leaving a Balancer liquidity pool entails a taxable event that yields capital profits or losses.

Understanding Various Taxes

  1. DeFi Lending Tax

    Taxation for DeFi transactions can be complicated due to the decentralized nature of these services. Generally speaking, any income generated from lending with DeFi protocols needs to be reported on your taxes as capital gains or earned income, depending on the amount and frequency of lending activity. If you have made a profit from these activities, then it will likely be subject to capital gains tax in most jurisdictions – though this can vary significantly depending on your country and local laws.

  2. Liquidity Mining Tax

    Liquidity mining is a way for cryptocurrency exchanges or projects to incentivize users by rewarding them with tokens for providing liquidity. In other words, it’s an incentive program designed to get people to trade and buy crypto assets on certain platforms. Any rewards earned from liquidity mining activities will also be subject to taxation rules. The amount of tax you owe may vary depending on your location and the type of rewards earned; however, generally speaking, these earnings will be taxed as capital gains or income based on your country’s laws.

  3. DeFi Staking Tax

    DeFi staking tax is a term that describes the taxes associated with decentralized finance (DeFi) staking. DeFi staking involves depositing cryptocurrencies into various protocols and earning rewards in exchange for liquidity or other services. These rewards are typically generated through yield farming, which can be quite profitable but is also subject to government taxation. As such, it’s important for any investor participating in DeFi staking to understand their local tax implications.

    Generally speaking, when one provides liquidity or participates in yield farming activities on the Ethereum blockchain, they may be liable to pay capital gains taxes depending on their jurisdiction. If an individual profits from DeFi staking, they must declare this as taxable income and pay the relevant taxes accordingly.

  4. Yield Farming Tax

    Yield farming tax is complicated since yield farming comprises many separate transactions. The taxes will be determined by the specific DeFi protocols you’ve stacked or the yield farming procedures you employ. However, you will be subject to Capital Gains Tax if you sell, swap, or spend tokens or coins in your yield farming activities. If you receive new coins or tokens as a result of your yield farming efforts, it’ll also be considered a taxable event.

  5. DeFi Interest Tax

    When using DeFi protocols, you either earn interest or pay interest. If you’re paying interest – the tax treatment will depend on whether those payments are made in cryptocurrency or US dollars. If your interest payments are only made using fiat currency, you won’t have to pay any tax. But if you are paying your tax using cryptocurrencies, it would be seen as spending on goods and services, and you’ll have to pay Capital Gains Tax.

On the other hand, if you are earning interest from DeFi protocols, it will be seen as an additional income, thus making you liable for paying Income tax.

Play-to-earn Tax

The IRS provides no guidance on the play-to-earn taxation of various DeFi games. As a result, you must consider your specific transactions and how they fit under the IRS’s current crypto tax guidance.

If you’ve seen gaining new tokens, such as SLP or AXS tokens, from playing Axie Infinity, this is likely to be considered income and liable to Income Tax.

Meanwhile, if you sell or trade tokens or NFTs, such as on Sandbox, this is more likely to be considered a capital asset disposal and liable to Capital Gains Tax.

Margin trading, Derivatives and other CFDs tax

The Internal Revenue Service (IRS) has not established any yearly filing requirements for paying taxes on margin trades, derivatives, and other contracts on centralized or decentralized exchanges. However, we can still adhere to the general guidelines for margin trading and selling both traditional margin trading products and derivative products in cryptocurrency.

If you are considered to be engaging in trading as a single investor, you will be liable to pay Capital Gains Tax on any profits accrued from margin trades, derivatives, and other CFDs. This means that you are not required to pay tax when you establish the position, however, you will need to pay tax when you terminate the position and gain a capital gain.

If a margin call leads to liquidation, the transaction must be reported to the IRS from a tax perspective as a disposal.

Transaction Fees and Transfer Fees Tax

Transaction fees, or network fees, are usually required when executing cryptocurrency-based transactions on the blockchain. These fees are generally paid in the form of cryptocurrency coins and can vary from network to network or transaction type. Transaction fees are taxable for capital gains.

Transfer fees can be seen as a kind of maintenance cost and cannot be added to your cost basis. Taking a conservative approach, these fees should be treated as a disposal and thus subject to Capital Gains Tax. As crypto will generally be used to pay for these fees, it is considered spending crypto on goods or services and, therefore, must also be subject to Capital Gains Tax.

Wrapped Tokens Tax

Wrapping a token is swapping it for another token, which could be regarded as a crypto-to-crypto transaction, and subject to Capital Gains Tax. Even if no gain or loss is made in the process (as the two tokens have the same value), this exchange of tokens may still need to be reported to the IRS as a disposal for taxation purposes.

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