DeFi Tax 101: Everything You Need to Know about Tax on DeFi
In brief: goodbye to traditional finance
The explosion of decentralised finance (DeFi) has brought access to such platforms to a wide base of users – from individual users to institutional investors and international organisations. DeFi gave us a new ecosystem of investment opportunities characterised by sophisticated financial transactions available to all kinds of users in multiple locations.
Tax offices worldwide made it pretty clear that crypto is subject to tax. Many of them have failed to provide guidance on novel investment opportunities, such as DeFi investments. DeFi crypto taxes vary depending on where you live and how your native tax office views that sort of investment.
Trying to find out how to adhere to new rules imposed on technological innovations can be tricky because regulators have not been successful in keeping up with the rapid development of technology. The rule when it comes to crypto is always ‘Do Your Own Research’ aka DYOR.
Since there is no uniformity when it comes to crypto taxes around the world yet, we suggest checking the specific rules where you live, but we will give a general overview in this article.
How to pay taxes in the crypto world?
Generally speaking, crypto is subject to two types of taxes – Capital Gains Tax and Income Tax. What you will pay may generally come to whether you are seen to have a capital gain or additional income. When it comes to Decentralised Finance (DeFi), this all comes down to how your specific DeFi protocol works and the existing guidance by your native tax institution.
In fact, most transactions you can conduct on various DeFi protocols will probably have existing guidance from the tax authority. For instance, the majority of tax offices clearly stated that selling or trading crypto for crypto is a disposal, and any gain is subject to the Capital Gains Tax. This applies both to decentralised exchanges and centralised exchanges.
Problems may arise when it comes to a variety of other common DeFi transactions such as staking, lending, liquidity mining, and yield farming where existing guidance provided by tax authorities isn’t as clear.
Tax implications are a risk you have to consider anytime you are dealing with financial products. It has been clear for centuries that you need to pay taxes. The main issue is that, when it comes to new financial products, users are not provided with clear guidance by financial institutions on how to pay taxes exactly.
If you want to find out about other risks associated with DeFi, we suggest reading this article: 'How to earn crypto: What are the risks of DeFi?'.
What is Decentralised Finance (DeFi)?
A short definition could sound something like this – DeFi is a new financial technology based on secure distributed ledgers similar to those used by cryptocurrencies. By enabling peer-to-peer digital exchanges, DeFi presents a system for providing open access to financial services.
DeFi is a system for providing open access to financial services by recreating tools of traditional finance and using them in a crypto environment. Blockchain technology is used as the means of distributing, recording, and storing value. For example, think of all services provided by banks such as credit, lending, savings, and insurance. All this provides DeFi, but in a permissionless and decentralised setting.
In contrast to traditional financial institutions that the crypto community refers to as ‘the middlemen’ or ‘intermediaries’ that charge fees for the use of their services, DeFi provides a different world of finance. Since it removes third parties from the picture, DeFi eliminates the fees. Individual users hold money in secure digital wallets instead of a traditional bank account and fund transfers can be completed in a few minutes.
A DeFi platform allows cryptocurrency holders to, for example, lend and borrow crypto assets without going through more traditional and cumbersome financial markets.
We have explained what DeFi is in our ‘How to earn crypto: Earning from DeFi’ article. Read it to learn more about the new permissionless finance based on blockchain technology.
How does DeFi work?
DeFi relies on the use of blockchain technology similar to cryptocurrencies. Blockchain presents a distributed database or ledger. Then there are decentralised applications (dApps) that are used to handle financial transactions on the blockchain.
Financial transactions are recorded in blocks and verified by other users. If such verifiers agree on a transaction, the block is closed and another block is created that contains information about the previous block within it. Therefore, the blocks are somehow chained together through the information in each subsequent block. Information cannot be altered without affecting all the blocks.
It seems like the chain is unbreakable. The innovation that blockchain technology brings to the table is that blockchains are resistant to retroactive modification. Data is stored in a safe way without any centralised authority or any other type of intermediary.
If you are new to the crypto world, we suggest reading this article: ‘Crypto Basics: What is a Blockchain’.
Key features of DeFi
a. Accessibility
Anyone that has an internet connection can access DeFi platforms. DeFi is a permissionless system that anyone can use. Financial transactions happen without any territorial restrictions.
b. Transparency and Security
Due to smart contracts that are published on a blockchain, anyone can review completed transactions. Financial transactions are highly auditable. The transparent nature, along with the blockchain’s immutability, enhances trust and decreases corruption.
Take a look at our 'How to use crypto: Getting started with DeFi' article to learn more about how DeFi uses smart contracts.
c. Autonomy
As mentioned above, DeFi platforms remove the need for any sort of intermediary. The new finance doesn’t rely on centralised financial institutions. Therefore, it is not subject to bankruptcy or adversity.
d. High interest rates and low transaction fees
Parties are enabled to directly negotiate interest rates and execute their deal fairly through the use of smart contracts. Since it is a decentralised world in which centralised financial institutions don’t charge a bunch of fees for each of their services or completed transactions, the fees are low.
Use cases of DeFi
DeFi isn't that complicated. The umbrella term that is made of financial products and services in a decentralised ecosystem mostly mirrors use cases of traditional finance. Let's take a look at some popular options.
a. Decentralised lending & borrowing
One of the most common use examples refers to lending platforms. Such platforms are mainly simple decentralised applications (dApps) that enable users to either lend their digital assets out to other users to earn interest or borrow digital assets and pay interest on top.
DeFi allows users to lend and borrow assets without the use of an intermediary. It is a much easier process in comparison to traditional banking services since borrowers don’t have to undergo the longstanding credit check process.
b. Decentralised exchanges
Decentralised exchanges (DEXs) are crypto asset trading platforms that function without a middleman. The popular method of trading digital assets doesn’t have a company or intermediary standing between buyers and sellers.
The maths behind DEXs is pretty clear. Crypto exchanges use software to automatically match buyers and sellers and execute the transaction. These trading platforms may use automated market-making to set the price of tokens in a liquidity pool or set out a bid system for traders to set their order prices.
If you are a frequent reader, you probably remember that we examined DEXs in this article: ‘Crypto Basics: What Are Decentralised Crypto Exchanges? DEX Explained’.
c. Yield farming
Yield farming, also known as liquidity mining, can be defined as a practice of locking up crypto assets in return for rewards automatically executed by a smart contract.
In most cases, yield farming projects require users to stake liquidity provider tokens. You can get these tokens after providing liquidity at particular decentralised exchanges such as Uniswap. For example, Uniswap allows users to contribute crypto to liquidity pools to earn income.
Even though they sound alike, yield farming differs from staking. Staking generates a return from helping blockchains process transactions.
If you are not familiar with these terms, we recommend reading this article: ‘How to earn crypto: What is Yield Farming?’.
d. Crypto staking
You probably heard about staking as a good way to earn passive income. However, it is more meaningful than just earning passively. Staking crypto includes committing your digital assets to help secure a blockchain and verify financial transactions.
Staking is usually one of the first ways many crypto asset holders enter into DeFi. The term refers to the process of helping to participate in the blockchain network's governance of Proof-of-Stake (PoS) blockchains.
If staking is something that might interest you, why not read this article: 'How to earn crypto: What is Staking? Earning Rewards and Minimising Risks of Staking'.
e. Decentralised insurance
Think of traditional insurance services – it is normal to take out insurance against a wide range of unfortunate or unforeseen events using insurance brokers as intermediaries. In the decentralised ecosystem, insurance can be used to hedge against potentially devastating events such as hacking, failure of smart contracts, market crashes, and similar.
The good sides of decentralised insurance are linked to auditable smart contracts with terms of payout for everyone to see. In other words, there is no danger from the insurance contract’s fine print. The second attribute refers to the possibility of a pool of investors sharing the risk among themselves in return for the insurance premium.
How are common DeFi transactions taxed?
In this article, we are barely scratching the surface regarding tax implications of DeFi investments. Most tax offices worldwide haven’t provided yet clear guidance on DeFi tax.
However, tax institutions laid down clear guidance when it comes to crypto taxation. Crypto tax always falls under two different types of tax, either Income Tax or Capital Gains Tax, depending on whether your digital investment is regarded as a regular income or seen as an asset disposal.
Let’s break it down. Your crypto investment, either DeFi or something else, is going to be seen in one of these ways from a tax office’s perspective:
a. Income tax
Income Tax is a type of tax governments impose on income generated by individuals and businesses within their jurisdiction. It is used to fund public services, provide goods for citizens and pay government obligations.
Personal income tax is a type of income tax imposed on an individual’s wages, salaries, and other types of income whilst business income taxes apply to corporations, small businesses, partnerships, and self-employed individuals.
In the crypto context, it is seen as you are making money, like any other form of income. Examples of crypto income may include being paid in a salary, staking, and mining.
Therefore, if you are earning crypto, it is taxed as an income. It is seen as you are making money, just like any other form of income. If you receive crypto, or another digital asset, as part of a DeFi transaction, that crypto is going to be considered and taxed as ordinary income. Yet, 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.
b. Capital gains tax
The Capital Gains Tax is the levy on the profit that an investor makes when an investment is sold. You owe capital gains tax for the tax year during which the investment is sold.
Capital gains taxes apply to so-called ‘capital assets’ which include stocks, bonds, digital assets such as cryptocurrencies and NFTs, jewellery, real estate, and coin collections.
Capital Gains Tax includes long-term gains and short-term gains. Long-term gains are levied on investment profits held for more than a year whilst short-term gains are taxed at the individual’s regular income tax rate.
In the crypto context, this type of tax is seen as disposing of a capital asset. Examples of crypto capital gains include selling your crypto for fiat currency, swapping it for another crypto, spending it on goods or services, and even gifting it in some jurisdictions.
Therefore, if you are swapping, spending, or selling crypto, you have to pay Capital Gains tax.
A practical example of capital gains
Let's lay down a simple example regarding Ethereum (ETH). If you are not quite familiar with Ethereum we suggest taking a look at one of our past articles: 'Crypto basics: What is Ethereum'.
When you lend your ETH to the Ethereum pool on Compound, you receive rewards paid in Compound Ether (CETH). Compound Ether is an ERC-20 token. As the ETH moves around in the liquidity pool, the CETH becomes worth more ETH over time. When you exit the pool and return the CETH, you receive 5 ETH back.
What does that mean for taxes? Well, swapping ETH for ETH and CETH back to ETH is a taxable event that triggers a capital gain or loss. When you sell or trade governance tokens that have increased in market value since you received them, you owe Capital Gains Tax.
Yield farming and liquidity mining taxes
Yield farming, also known as liquidity mining, can refer to a broad number of investment activities. It has emerged as a new way to maximise returns by putting digital assets to work. Simply, a crypto exchange requires liquidity to facilitate trades, lending, and other financial activities.
To do this, crypto assets are combined into liquidity pools to provide liquidity to the marketplaces. In exchange for their digital assets, liquidity providers receive liquidity pool tokens representing their share of the tokens in the liquidity pool, as well as interest and reward tokens.
To determine which tax you need to pay on liquidity meaning depends on the specific DeFi protocol you are using and how it rewards you. For example, some DeFi protocols reward you with one token in exchange for your crypto asset. You don’t earn multiple tokens the longer you leave your assets in the liquidity pool as the value increases the more active the pool is. In this situation, you are not earning new crypto because you will only realise a profit or gain when you sell your token. This taxable event would likely be seen as a capital gain that is subject to Capital Gains Tax.
On the other hand, some DeFi protocols reward you with multiple tokens for providing liquidity. In simple words, you are receiving new crypto in exchange for the liquidity service you are providing. Since this taxable event means that you are earning new tokens, it is more likely that this situation would be regarded as income and subject to Income Tax.
Therefore, if you are earning new tokens through liquidity mining, tax consequences are subject to Income Tax. If the balance of tokens stays constant but increases in value, the taxable event is subject to the Capital Gains Tax.
What happens if you add liquidity?
If you are adding capital to liquidity pools, you are technically not disposing of your crypto asset. You are just moving your capital to another place that amounts to a transfer which is not seen as a taxable event. If there is no disposal and you have no ordinary income, adding liquidity is not subject to either Income or Capital Gains Tax.
Keep in mind that if you receive a token in exchange for adding capital, this could be viewed as swapping crypto which is a taxable event and make it subject to Capital Gains Tax.
What happens if you remove liquidity?
If you decide to take back your original funds from a liquidity pool, you are not disposing of any of your crypto assets or receiving any new funds. Therefore, you don’t need to pay tax.
Similar to adding liquidity, if you have received a token in exchange for your funds and you are swapping the token back for your asset, this could be regarded as swapping crypto. Again, this is a taxable event subject to Capital Gains Tax.
DeFi staking tax
Staking taxes are more simple than the previous examples since many tax offices worldwide have already issued guidance on staking. A broad number of tax institutions view staking rewards as a type of additional income and subject it to Income Tax.
For example, let’s take a look at the IRS Notice 2014-21. Similar to other tax authorities around the world, the U.S. Internal Revenue Service (IRS) didn’t issue any specific guidance on staking, but its guidance on mining tells us that there could be DeFi tax implications for staking activities due to its similarities to mining.
Therefore, according to the IRS guidance on mining income, a staking reward is taxable as ordinary income at its fair market value on the date you receive it. However, if you sell the crypto received as a staking reward later, you will owe Capital Gains tax on any increase in value.
You remember how we mentioned long-term and short-term gains. If you sold the crypto received as a staking reward that increased in value, the gains will be regarded as short-term or long-term, depending on whether your holding period is less or greater than one tax year.
A practical example: When do you need to pay DeFi taxes on staking?
Let’s imagine that you have 5 ETH worth $20,000. You decide to stake your capital in a staking pool that pays 7% APY net of fees. APY stands for Annual Percentage Yield. In banking it refers to the actual rate of return you will earn on your checking or savings account.
In the same year you generate more ETH worth $1,450 and you take your capital out of the pool. After six months, you decide to sell the ETH worth $1,450. However, its value has increased in those six months up to $1,800.
In line with this scenario, you should include the original staking reward – the sum of $1,450 in your gross income for the year. It may be taxable at your ordinary income rate, similar to the taxation of normal paycheck funds.
DeFi interest expense: Is interest a taxable event?
This one is simple. Just like you would deposit fiat currency into a savings account with a bank and earn interest or even compound interest, you can do the same thing with your crypto. The tax treatment of many jurisdictions differs whether you are paying or earning interest.
If you borrow crypto assets and pay interest accordingly, you are not earning income or making any kind of disposal. Therefore, you don’t need to pay taxes. However, keep in mind that if you are paying interest in cryptocurrency, this could be seen as spending crypto on goods or services. In that case, the Capital Gains Tax is relevant.
It is different if you are earning interest as a result of loaning your digital assets. This can be seen as a type of taxable income since you are getting something in return for a service. In many countries this is regarded as income, opening the doors for income tax liability.
Crypto interest is simply subject to Income Tax, but it gets a bit complicated if you dispose of the interest by selling, swapping, gifting, or spending it. Any profit that comes out of these activities will amount to the applicability of the Capital Gains Tax. This is because crypto is seen as an asset for tax purposes, such as a stock. Whenever you dispose of an asset, tax offices think of it as a capital gain or loss.
What about investment interest expenses?
Investment interest expense is subject to special tax rules. Since special rules apply, it is important to track these separately. Keep in mind that investment such expenses are mostly deductible only up to your net investment income.
Many jurisdictions include a bunch of incentives to enhance investment activities. One of them is the tax deduction for investment interest expenses.
Let’s present a real-world scenario. For example, when you borrow money to buy property for investment purposes, any interest you pay on the borrowed money becomes an investment interest expense. You can take out a $10,000 loan and use it to buy stock. The same thing applies to crypto.
Regulating DeFi taxes: United States vs United Kingdom
We have mentioned several times how taxes and taxable events may differ in various jurisdictions. Therefore, we are going to examine two countries that have been most progressive when it comes to crypto taxes.
DeFi taxes from the US perspective
Income taxation in the U.S. is generally transactional. Simply speaking, it is imposed at the time of receipt or sale of a token with certain exceptions. It is guided by the economics of the activity more than the formal structure of such activity.
Returns received from investments can be categorised as income subject to ordinary tax rates or gain on a capital asset. In the U.S. cryptocurrency is taxed as property. However, there aren’t any niche tax rules as in other niches such as securities or commodities.
The IRS has plenty of guidance papers on crypto taxes in the U.S. and many of them may apply to DeFi investments and transactions. It all comes down to the way the IRS views your crypto assets – is it a disposal of a capital asset or an income?
If you receive crypto or another type of digital asset as a part of a DeFi transaction in return for goods or services, that crypto is going to be taxed as ordinary income by the IRS. However, if it increases in value, the gain recognized at a later date when being sold or disposed of will be taxed as a capital gain.
The UK stepped up with new guidance on DeFi taxes
On 2 February 2023, the United Kingdom’s taxing department, Her Majesty’s Revenue and Customs (HMRC) published the Crypto Assets Manual, an updated guidance on the treatment of crypto assets. The guidance was deemed controversial by the wider audience and received a negative backlash.
Whether it is good or bad, the country decided to specifically regulate DeFi investments and transactions. The manual contains a separate section dedicated to DeFi lending and staking regulations in the UK and answers directly the question of whether returns or rewards from DeFi services can be deemed as either capital or income when taxed.
The British tax authority acknowledges that there is no single operating model for DeFi lending platforms and it is important to consider the terms and conditions to determine tax consequences. The key to determining tax implications lies in the nature of the return and whether such activities form part of a trade.
The Manual states that returns via staking or lending DeFi assets shall be treated as property for tax purposes. The updated guidance notes that the making and repayment of DeFi loans and staking rewards may give rise to a disposal of a chargeable asset and become subject to Capital Gains Tax.
When it comes to DeFi interest tax, the Manual states that the return earned by the lender, or the liquidity provider shall not be considered interest since cryptocurrency is not considered as money in the UK. Instead, tax implications will be determined by whether the receipt has the nature of capital or income.
Since this is a beginner’s guide there is no need to complicate things further. The Manual contains some parts which state that when token holders stake their assets, the ownership is transferred to the platform. Due to such provisions, the updated guidance was met with backlash from the crypto community since the final result could be burdensome for stakers and make declaring crypto taxes even more complicated.
Are some DeFi transactions not taxable?
While the regulation of DeFi tax is not the same worldwide, there are some common situations that are not taxable events.
Buying crypto with fiat money is not taxable until you sell it or use it to make a purchase. If you are just buying crypto, you don’t owe tax. We have mentioned that gifting may be taxable in some countries. Most jurisdictions consider gifting as a non-taxable event if it is below the allowable limit.
Finally, transferring crypto assets between your own wallets is not taxable as well. That is just a transfer of assets. For example, you buy Ethereum Classic (ETC) from a decentralised exchange and send it to your non-custodial software wallet. Then you decide to send these assets to your hardware wallet or return them to the crypto exchange from which you originally drew them. When you only transfer assets, you don’t have to think about paying taxes.