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DeFi Crypto Taxes in 2020: Complete Tax Guide

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by William Carlsen · Updated Dec. 29, 2020

The Decentralized Finance (DeFi) ecosystem has without doubt been the hottest topic in the cryptocurrency industry in 2020. With the emergence of DeFi protocols built on Ethereum, crypto holders have now the opportunity to stack more sats by putting their crypto assets to work.

However, with this new technology comes also the question about how to report and file DeFi taxes. In this article, we will study the current tax implications of DeFi transactions, and also explain how to correctly report activities like yield farming, liquidity mining, lending, and borrowing to avoid problems with the tax authority.

More specifically, these are the topics and questions we will address in this article:

  1. The basics of crypto taxes
  2. What is DeFi?
  3. DeFi lending taxes
  4. Yield farming taxes
  5. Loans, interest, and liquidations
  6. DeFi taxes for different platforms
  7. Solution: How to file DeFi taxes
  8. Conclusion

Basics of Crypto Taxes

Cryptocurrencies are generally speaking subject to both capital gains and income taxation in most countries, and this includes also the US, Australia, Canada, the UK, and the majority of other countries in Europe. Similar to stocks, capital gains must be calculated every time you sell, trade, or exchange any type of crypto asset. This must then be reported on your annual tax return.

Any crypto received in the form of mining or staking rewards, airdrops, or interest payments is considered as income and must also be reported. Income from cryptocurrency should be reported as the Fair Market Value (FMV) on the date of the transaction.

Since DeFi is a rather new subsector within the crypto industry as a whole, no specific tax regulations exist today that directly addresses the DeFi ecosystem. However, many tax authorities, including the IRS in the US, have released general guidelines for the tax treatment of cryptocurrencies which we can use to better understand how DeFi transactions are taxed today.

If you want to learn more about the general rules for how Bitcoin and other cryptocurrencies are taxed, we recommend that you read our Complete Cryptorrency Tax Guide 2020.

What is DeFi?

DeFi is short for Decentralized Finance and is a field of cryptocurrency that enables people to access traditional financial services such as borrowing and lending without the use of middlemen (eg. banks, financial institutions, etc). Some of the benefits DeFi provides are reduced costs, less delay, and increased trust by the use of smart contracts and blockchain technology.

Today, most of the popular DeFi applications are built on top of the Ethereum network. Many of the platforms that emerged in 2020 have already seen a rapid increase in user adoption in a very short amount of time. Decentralized trading and Automated Market Making (AMM) have especially attracted a large number of crypto traders by offering an alternative to centralized exchanges.

With DeFi comes also some rather special and unique tax situations which is important to understand. This article will focus on DeFi transactions within the Ethereum ecosystem, but the general guidelines explained can also be applied to other platforms on other blockchains.

If you want to get a better understanding of what DeFi is all about, we recommend that you read our in-depth DeFi guide: A Beginner’s Guide to Decentralized Finance in 2020.

DeFi Lending Taxes

Several platforms allow you to lend out cryptocurrency to receive interest. Any income received from crypto lending is subject to either capital gains or income tax and depends on which platform you are using.

This is actually an important difference because it might have an impact on how much taxes you will be paying.

Next, we will look at this in more detail.

Ordinary income from DeFi lending

Generally speaking, interest received in the same currency as what you have lent out will be classified as ordinary income for tax purposes. This applies to both the traditional financial system (eg. interest paid by your bank), centralized crypto lending platforms (BlockFi, Celsius), and DeFi platforms.

Let’s say you have locked up ETH in a DeFi platform that pays a daily interest in the same currency – ETH in this case. This means your wallet balance will increase each day until you decide to cancel the lending agreement and withdraw your tokens. This is similar to interest received in your bank account and is therefore considered ordinary income for tax purposes.

This type of income will simply be taxed similar to your ordinary income. If you are from the US, you can see the different tax brackets for 2020 on this page.

Capital gains from DeFi lending

Today, many of the most popular DeFi platforms have issued their own tokens, often referred to as Liquidity Pool Tokens (LPTs).

The way this works is that you first need to swap token A (eg. ETH) for token B (eg. cETH) which is an LPT. Such tokens represent the portion of your stake in the total liquidity pool. Instead of receiving interest in the form of new tokens, the value of your stake increases while the number of LPTs in your wallet stays the same. This means that you will receive more tokens (eg. ETH) when you later swap your LPTs back for the underlying asset.

From a practical perspective, you are swapping tokens on two occasions – both of which trigger capital gains tax. This is because such swaps are considered similar to trading one cryptocurrency for another.

Next, we will look at two examples with lending on Aave and Compound to understand this better.

Example: Lending on Aave

Lucas buys 2 ETH for $550, and a few months later he decides to lend out his ETH on the Aave platform. At this time, his 2 ETH has increased in value and is now worth $800. Lucas receives aETH tokens in the ratio 1:1 when lending out his ETH on Aave. Lucas keeps the aETH tokens for 2 months until he later swaps them back for ETH and earns a total interest of 0.3 aETH during this period. At the time when he swaps aETH back to ETH, the value of his 2 ETH has decreased to $700.

We can now break down all the taxable transactions this way:

1) Swapping ETH → aETH
When Lucas swaps 2 ETH for 2 aETH he needs to calculate capital gains for the 2 ETH disposed. His original cost basis is $550 so we find the capital gains directly this way:

capital gains = $800 – $550 = $250 (gain)

2) Interest received (aETH)
Lucas received a total interest of 0.3 aETH. We assume this was worth $120 at the time when he received the tokens to his wallet. This will be considered as ordinary income and not capital gains. This value ($120) will also be the cost basis for his 0.3 aETH.

3) Swapping aETH →  ETH
When Lucas decides to swap aETH back to ETH, he needs to calculate capital gains for the 2.3 aETH he currently has in his wallet. The cost basis is found as $800 + $120 = $920. The sales price of 2.3 aETH is found as 2.3/2*$700 = $805. Therefore, we calculate the resulting capital gains this way:

capital gains = $805 – $920 = -$115 (loss)

To summarize his taxable transactions:

  • Ordinary income: $120
  • Net capital gains: $135

DeFi platforms like Compound work a bit differently than Aave explained in the previous example. Rather than being paid interest by receiving more tokens to your wallet, Compound’s LPT will simply increase in value instead. This means that the tokens will become convertible for an increasing quantity of the underlying asset with time.

Example: Lending on Compound

Dave wants to make his crypto “work for him” and decides therefore to lend some of his ETH on the Compound platform. He converts 1 ETH to 30 cETH when the price of ETH is $600. The original cost basis for his 1 ETH is $350. After 3 months he decides to swap the cETH back for ETH. By this time, the value of his 30cETH has increased to 1.01 ETH. The market rate of ETH is $700 at the time when he swapped the cETH back to ETH.

This is the taxable outcome for Dave’s transactions:

1) Swapping ETH → cETH
When Dave swaps 1 ETH for 30 cETH he needs to calculate capital gains for the 1 ETH disposed. His original cost basis is $350 so we find the capital gains directly this way:

capital gains = $600 – $350 = $250 (gain)

2) Swapping cETH →  ETH
When Dave decides to swap cETH back to ETH, he needs to calculate capital gains for the 30 cETH he currently has in his wallet. The original cost basis is $600, and the sales price is found as 1.01*$700 = $707. Therefore, we calculate the resulting capital gains this way:

capital gains = $707 – $600 = $107 (gain)

His total capital gains are found as $250 + $107 = $357 and this must be reported on his annual tax return next year.

As should be clear now, calculating taxes for DeFi transactions can easily become very complicated if done manually. That’s why most people prefer to use cryptocurrency tax software to automate the calculations and download all tax reports and tax forms with the click of a button.

Tip: Free Cryptocurrency Tax Software

Coinpanda is a popular software for cryptocurrency tax calculations and can also handle all DeFi transactions from Aave, Compound and other DeFi platforms.

This is how it works:

Step 1: Register for a 100% free account and add wallets for each of your ETH addresses.

Step 2: Add your public address to each wallet and the software will automatically import all transactions from interaction with DeFi protocols.

That’s it! Get started today by signing up for a free account.

Yield Farming Taxes

By supplying liquidity to decentralized marketplaces like Uniswap, Balancer and Bancor, crypto investors can now earn yield on their crypto assets. The concept of earning yield by providing liquidity to such platforms is also referred to as yield farming or liquidity mining.

The term Yield Farmers is often used to describe people always looking for the highest yield possible. With new DeFi platforms emerging almost every week, yield farmers are often competing with each other to be the first to discover the “next big DeFi platform” before everyone else. Because the percentage rewards are often highest in the beginning, it can be very lucrative to be one of the first yield farmers to discover and start mining liquidity on a new platform.

When it comes to taxes, crypto received from yield farming is subject to the same tax implications discussed previously. This means that depending on which platform you have used, you need to either pay ordinary income tax or capital gains tax (or both) on interest received from lending your cryptocurrency.

DeFi governance tokens

An important piece of the DeFi yield farming puzzle is earning governance and incentive tokens. These tokens are used to further incentivize crypto holders, or yield farmers, to use their crypto assets as collateral to provide liquidity. This can be very attractive because it further increases the total earnings.

Two popular governance tokens that are distributed to liquidity providers today are COMP (Compound) and BAL (Balancer). When you are distributed such tokens you will need to report this as ordinary income per their market value on the date you received the tokens in your wallet.

It’s important to keep in mind that you will also recognize any capital gain (or loss) when you later sell these tokens.

Example: Received COMP tokens

Oliver provides liquidity to Compound and receives COMP tokens as an incentive for lending out his ETH. He has received 1 COMP token on three occasions:

  • 5th of November 2020 ($94)
  • 20th of November 2020 ($116)
  • 5th of December 2020 ($140)

The total income from COMP which Oliver needs to pay ordinary income tax on is therefore found as:

ordinary income = $94 + $116 + $140 = $350

On the 6th of December, he decides to convert all COMP tokens to USD. He receives 450 USD which means we find his capital gains as:

capital gains = $450 – $350 = $100

Loans, Interest and Liquidations

The general rule is that capital gains tax is triggered every time you trade, exchange, or otherwise dispose of a crypto asset. In the event of taking out a crypto loan, you are actually not exchanging/swapping/trading any asset which means you also don’t realize any tax!

This applies as long as your collateral is not liquidated so that the platform returns your whole collateral when you later pay back the loan. This has obvious tax advantages by providing opportunities without triggering any taxes.

However, if your collateral is liquidated, you are actually realizing any capital gain or loss on those assets because this is treated similar to selling and receiving fiat in return.

Loan interest payments

It’s clear now that you are not paying any taxes as long as your collateral is not liquidated or converted to another cryptocurrency, but what about loan interest payments? Are you allowed to report this as tax-deductible costs?

Since crypto lending and borrowing is a rather new and experimental phenomenon, the current tax guidance in most countries including the US does not comment on this specifically. To understand the most likely tax implications better, we can look at the current guidelines for traditional lending and borrowing.

In the US, whether you are allowed to get tax deductions for interest payments depends on if the loan is used for personal, investment, or business-related purposes. Interest expenses for personal loans are generally not considered tax-deductible. In the case of an investment loan, related expenses are subject to special tax rules and have certain limitations. If you borrow funds and use them for yield farming, the loan is likely to be classified as an investment loan.

DeFi Taxes for Different Plaforms

We have so far in this article looked at the general tax implications for different DeFi transactions like lending, borrowing, yield farming, and liquidity mining. In this section, we will look closer at some of the most popular DeFi platforms today and their tax implications on a high level.

Aave

Aave is recognized by many to be the leading DeFi platform today. The protocol enables users to borrow assets or earn interest on deposits by providing liquidity to the Aave ecosystem.

Taxes on Aave

  • You recognize capital gains/losses on the asset you exchange away when minting aTokens
  • You recognize capital gains/losses on aTokens when you convert these back to the underlying asset (eg. ETH)
  • Received interest (aTokens) is treated as ordinary income for tax purposes. This should be reported as the market value of the tokens at the time of receipt.

Uniswap

Uniswap is an Automated Market Maker (AMM) protocol and has become hugely popular in 2020. The platform lets you either earn interest by providing liquidity or make swaps between different cryptocurrencies.

Taxes on Uniswap

  • Token swaps on Uniswap are considered equal to trades and triggers capital gains or losses
  • When providing liquidity to a pool, you are disposing of cryptocurrency and receive LP tokens representing your share of the total pool. This is a taxable event triggering capital gains or losses on the assets disposed of.
  • To receive the underlying liquidity back + any fees earned, you must burn your liquidity (LP) tokens. This is also a taxable event triggering capital gains on the tokens disposed of.

Compound

Compound is in many ways similar to Aave by offering users to borrow, lend, and earn interest on their crypto assets. We have already included several examples covering the tax implications of DeFi transactions on Compound in this article. We can summarize it this way:

Taxes on Compound

  • You recognize capital gains/losses when exchanging cryptocurrency for cTokens (eg. cETH)
  • Your cTokens will accrue value as long as you are lending out your crypto. Converting cTokens back to the underlying asset is a taxable event and triggers capital gains tax.
  • Any earned COMP is taxed as ordinary income

Balancer

Balancer is similar to Uniswap by being an Automated Market Maker protocol allowing people to either earn interest by offer liquidity or swap cryptocurrencies.

Taxes on Balancer

  • Token swaps on Balancer are considered equal to trades and triggers capital gains or losses
  • When providing liquidity on Balancer, you are exchanging crypto assets for BPT (Balancer Pool Tokens) which represents your shares in the pool. These tokens increase in value as you earn interest, and you will therefore recognize capital gains when you later trade the BPT tokens back for the crypto you deposited.
  • Any earned BAL (Balancer Governance Token) is taxed as ordinary income

Maker

Maker has been around for a long time already, and allows users to trade tokens, borrow Dai, and earn savings on the Oasis platform.

Taxes on Maker

  • Trades made on the Oasis platform are considered normal crypto trades and are therefore subject to capital gains tax
  • Any earned DAI is taxed as ordinary income

Solution: How to File DeFi Taxes

We have in this article explained most of the typical tax implications you need to be aware of when interacting with DeFi platforms and protocols. This can easily become very challenging and timeconsuming unless you are an Excel sheet professional. That’s why most people prefer to use a cryptocurrency tax software that automatically keeps track of all your transactions and lets you download a PDF tax report with a summary of your capital gains and taxable income.

Coinpanda is one of very few crypto tax solutions that can accurately handle tax calculations for DeFi platforms today. Here is how you can calculate and report your taxes for DeFi easily using this software:

  • Step 1: Sign up for a 100% free account and add a wallet for each of your Ethererum addresses.
  • Step 2: Automatically import all DeFi transactions by adding your public address(es) to the wallets created in Step 1.
  • Step 3: When the wallets have finished syncing, you need to verify that all data is in fact imported correctly and that there are no warnings showing.
  • Step 4: Download your tax reports and tax forms (eg. Form 8949 for USA)

It is actually that easy! Get started with Coinpanda today.

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Coinpanda Transactions page shows a free tax preview for all transactions

Conclusion

We have in this article discussed the current tax implications for cryptocurrency transactions with DeFi platforms on a high level. Tax authorities around the world, including the IRS in USA, have so far not provided any specific tax guidance applicable to the DeFi ecosystem as a whole. Therefore, we need to infer tax implications for DeFi based on the general guidance on cryptocurrency.

Here are some of the most important take-aways for DeFi taxes:

  • A cryptocurrency swap is a taxable event similar to crypto trading on centralized exchanges
  • Exchanging crypto assets for LP tokens, which is staked to earn interest, is a taxable event similar to trading and triggers capital gains tax
  • Exchanging any LP tokens back to the deposited collateral is also a taxable event which triggers capital gains tax
  • Interest earned from receiving new tokens (ie. your balance increases) is subject to ordinary income tax at the fair market value at the time of receipt
  • Interest earned from your LP tokens increasing in value is taxed as capital gains when you exchange these for the underlying asset
  • Any governance tokens received (eg. COMP and BAL) is subject to income tax at their fair market value at the time of receipt

This article will be continuously updated whenever there are any updates from a tax legislative perspective that is applicable for DeFi platforms and protocols.

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