Decentralized Finance enables individuals and companies to conduct digital asset transactions without relying on intermediaries such as centralized brokerages, exchanges, or banks by using smart contracts on a blockchain. These transactions occur on peer-to-peer financial networks that use protocols, such as Uniswap and Proton, and are taxable according to current regulation, which is outlined at a high level in An Overview of DeFi Taxes: Yield Farming, Liquidity Pools, and More | TaxBit Blog.
The purpose of this article is to provide a high level overview of the most common DeFi transactions, explain how those transactions are mapped to TaxBit’s standardized transaction types, and describe the resulting treatment.
How are DeFi transactions taxed in the U.S.?
If you receive crypto, or another digital asset, as part of a DeFi transaction in return for goods or services, that crypto is going to be considered and taxed as ordinary income by the IRS.
If it increases in value, the gain you recognize at a later date when you sell or dispose of it will be taxed as a capital gain.
Common DeFi Transactions
A DeFi user cannot transact in Fiat currencies. Rather, DeFI transactions are conducted using digital assets and cryptocurrency. As a result, it is important to clarify what is taxable and what the economic implications of a transaction are.
The following DeFi transactions are supported by TaxBit and are mapped to the standardized TaxBit transaction types.
Swaps: a swap is a token for token trade, and is taxed as a trade with a realized gain/loss. For example, an individual could swap ETH for LTC. This is treated as a taxable disposition of ETH with a gain/loss calculated as the difference between the fair value of the ETH being disposed of and the cost basis of the ETH lot/s being disposed of. The fair value of the LTC received will establish the individual’s cost basis in that LTC lot. There will be a similar gain/loss calculated on any asset disposition to pay transaction fees. Individuals also benefit by including the fair value of the fee in the cost basis of the assets received.
Liquidity Pools: Individuals can contribute assets to a liquidity pool and receive a proportion of the transaction fees that are generated by the pool. When assets are contributed to a liquidity pool, an individual receives a Liquidity Pool NFT Token. The entry and exit from a Liquidity Pool is taxed as a Trade (as outlined above), which means there is a disposition of assets that are contributed to the pool and a corresponding recognition of the LP NFT Token (or if an individual is exiting a Liquidity Pool there is a disposition of the LP NFT Token and recognition of assets received). As a result, there is a realized gain/loss on the trade of assets (whether that be assets contributed in exchange for an LP NFT Token, or an LP NFT Token being exchanged for assets that were initially contributed to the pool). The same fee treatment outlined above for swaps/trades also applies.
Yield Farming: Yield farming, sometimes referred to as liquidity farming, is a very broad term in the DeFi space. It can relate to several different activities, but generally involves earning some sort of return on the crypto units you own.
Under the umbrella of yield farming, there are two basic activities—lending and staking. Despite the use of these terms, they don’t always reflect the true economics of DeFi transactions.
Yield Claiming: After an individual has contributed assets into a liquidity pool, they have the ability to claim their proportion of the fees that have been generated. This ability to claim “yield” (in the form of assets received), is comparable to staking rewards. The yield claimed is treated as Income and an individual recognizes income equal to the fair value of the assets received. In addition to an income recognition for the yield claimed, there is an expense recognized for the transaction fees necessary to claim the yield. In the Transactions page within the TaxBit Consumer App, the Expense and Income are split out into two separate transactions to accommodate their respective appropriate treatment, even though the transaction occurred simultaneously. There is a resulting gain/loss recognized on the expense transaction the same way there would be any other expense or disposition activity.
Voting/Approval: This is essentially a gas fee, paid in crypto, to record a Vote or Approval. This is recognized as an Expense transaction with a corresponding gain/loss realized similar to any other expense transaction or asset disposition.
Airdrops: If you received an airdrop of crypto into your wallet, you generally have to pay taxes on the proceeds. Typically, airdrops are recorded as an income transaction and are taxable as ordinary income at their fair market value on the date received. If you later dispose of your airdropped asset, you may also need to pay short-term or long-term capital gains as a part of the asset disposition transaction, similar to the swap scenario described above.
For any transaction to have an accurate taxable Gain/Loss calculation, the initial acquisition of each respective asset in an individual’s account must be included in the form of a Buy, Trade, or Income from the original data source. Because DeFi is only cryptocurrency transactions, there must be an additional data source included in an account with DeFi transactions or a manual transaction to represent the initial purchase or receipt of an asset.
For example, an individual could buy Wrapped BTC (WBTC) on Coinbase and then transfer that WBTC to a MetaMask wallet prior to performing a Swap (Trade) of WBTC for LTC on Uniswap. The Transfer In of WBTC to the MetaMask wallet will not set cost basis for the WBTC held in the MetaMask wallet. To identify the correct cost basis, you must also link the Coinbase account where WBTC was originally purchased from so the cost basis can be traced through the transfer activity. With all the relevant accounts linked, you will be able to see the correct Gain/Loss calculation that will occur when you swap the WBTC for LTC. As illustrated in this example, it is critical that an individual includes their exchange account/s in order to recognize the initial Buy of WBTC to avoid missing cost basis. By connecting all your transaction sources you’ll avoid experiencing missing cost basis and will accurately reflect all Gain/Loss calculations on all DeFi transactional activity.
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