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Despite the turbulent crypto winter, DeFi market TVL still remains over $50 billion, with millions of investors still involved. But as with all crypto investments, if you’ve got gains, your tax office will want its share. We’ve teamed up with crypto tax calculator Koinly to give you the rundown on all things DeFi tax.
How is DeFi taxed?
Let’s start with the obvious. Tax offices worldwide struggle to keep up with the crypto market as it rapidly evolves. As such, there’s actually very little guidance from tax offices around the world on newer investment opportunities in crypto, in particular, DeFi transactions.
This means it can get painfully confusing for DeFi investors when trying to navigate their tax obligations. They need to interpret the current guidance from their tax office and apply it to their DeFi transactions - or better still, have an experienced crypto accountant do it for them!
All this said, we can give a general overview of DeFi tax around the world to help you understand how your investments might be taxed - but it’s well worth checking the specific rules where you live in Koinly’s crypto tax guides.
Crypto Tax 101
We’ll start with the basics.
Broadly speaking, crypto will either be subject to Capital Gains Tax or Income Tax - or sometimes both. It depends on how your profit is viewed and whether you’re seen to have a capital gain or additional income.
When it comes to DeFi, it all comes down to the protocol you’re using, how it works, and the guidance from your tax office.
In some instances, you’ll have existing guidance you can refer to for DeFi transactions. For example, most tax offices have guidance stating that selling crypto for fiat currency, swapping one crypto for another cryptocurrency, and spending crypto is a disposal of an asset. So any gain from the transaction is subject to Capital Gains Tax. This guidance applies to decentralized exchanges, as well as centralized exchanges.
Of course, there are a lot of other common DeFi transactions such as staking, liquidity mining, lending, and yield farming that are completely lacking guidance. So it all comes down to how your specific DeFi protocol works as to the likely tax implications.
To break it down, we’ll look at some common transactions and the likely tax implications for each.
Liquidity pool taxes
Contributing to liquidity pools to earn passive income has become a popular DeFi investment strategy. But although it might appear like adding and removing your liquidity from a given pool is a tax free event, it’s not quite so straightforward.
Most tax offices are clear that trading one crypto for another is a disposal and therefore any gain from the transaction is subject to Capital Gains Tax.
This matters because most of the time when you add or remove liquidity, you’ll exchange liquidity pool tokens (LP tokens) to do so. So, for example, when you add liquidity to a pool, you’ll receive LP token(s) representing your capital in the pool. Similarly, when you want to remove your capital from the pool, you’ll trade your LP token(s) back to do so.
Many tax offices may view this as a crypto to crypto trade - which means every time you add or remove liquidity you have a disposal and therefore you’ll need to calculate a gain or loss.
Despite how harsh it might sound, this stance makes sense since, in many cases, you don’t earn new LP tokens as a reward, instead, your LP tokens accrue value. So it’s only at the point of withdrawing your LP tokens that you’ll realize a gain or loss.
Of course, not all liquidity pools work like the above. Some do pay out new tokens instead or even do a mix of both, and this may have different tax implications. So let’s take a look at a couple of examples to understand the various tax implications.
Example: PancakeSwap You add liquidity to a pool on PancakeSwap. You get LP tokens in return representing your share of the pool.
You’ll receive transaction fees as a reward for your added capital, but instead of getting new tokens, the value of your LP tokens increases. It’s only at the point you withdraw your capital from the pool by exchanging your LP tokens that you realize a gain.
In this example, your tax office may view adding and removing liquidity as a crypto-to-crypto trade and therefore any gain may be subject to Capital Gains Tax.
Example: Compound
You add liquidity to a Compound lending pool.
Like in our example above - you’ll get tokens in return for your capital, cTokens in this instance, and these tokens accrue value.
However, you’ll also receive COMP tokens for using the Compound protocol, which you can claim at any point.
So in this example, you may have three different taxable transactions. You may have taxable transactions when you add and remove liquidity by exchanging your cTokens - like a crypto to crypto trade - and any gain may be subject to Capital Gains Tax.
As well as this, as you’re earning new COMP tokens, your tax office may view this as a kind of additional income, and you may need to pay Income Tax based on the fair market value (FMV) of your COMP tokens at the point you received them.
Staking taxes
Some tax offices have released guidance on the taxation of staking rewards - but this generally refers to staking as part of a proof of stake consensus mechanism, not DeFi staking. For staking rewards from PoS staking, generally, tax offices agree that this is a kind of additional income and investors will pay Income Tax upon receipt based on the FMV of their staking reward tokens at the point they receive them.
However, when it comes to DeFi staking, it all comes down to how your protocol works. We’ll use an example to explain.
Example: SushiSwap
There are a couple of ways to stake on SushiSwap.
You can stake your SLP tokens to earn SUSHI tokens, and you can stake your SUSHI tokens to earn XSUSHI tokens. But these two staking transactions work very differently.
When you stake your SLP tokens to earn SUSHI tokens, you’ll earn new SUSHI tokens. In this instance, it’s likely to be viewed as additional income - like PoS staking rewards - and subject to Income Tax upon receipt.
Meanwhile, when you stake your SUSHI tokens to earn XSUSHI, you actually trade your SUSHI tokens for XSUSHI tokens which accrue value. It’s only when you unstake your SUSHI by trading your XSUSHI tokens back that you realize your reward. So in this instance, this is more likely to be viewed as a crypto to crypto trade and you may need to calculate a gain or loss, both at the point you stake your SUSHI tokens and when you unstake them.
Yield farming taxes
Yield farming can refer to a huge variety of different protocols - so like above, it all comes down to the specific protocol you’re using and how it works, as well as your tax office’s guidance.
Broadly speaking, the simplest way to look at it is any time you’re exchanging tokens - like LP tokens - it’s more likely your transaction will be viewed as capital income and subject to Capital Gains Tax. While if you’re earning new tokens, it’s more likely your transaction will be viewed as additional income and subject to Income Tax.
How to calculate, report and file your DeFi crypto taxes
If you’re an active investor with a variety of complicated transactions like DeFI, NFT, derivatives, or margin trades, calculating your crypto taxes takes hours of spreadsheets and calculations. Worse still, some tax offices, like the IRS, want you to report an excruciating amount of information - like every single time you disposed of crypto!
Fortunately, that’s where our partner Koinly comes in. Save yourself hours of pain, use Koinly crypto tax calculator, and follow these 5 easy steps to file your crypto taxes instead:
Connect all your wallets, exchanges, and blockchains to Koinly. You can do this automatically via API or by importing CSV files of your transaction history. Koinly supports more than 700 integrations, including Sorare. Learn more.
Grab a coffee and let Koinly do its stuff. Koinly will collate your entire crypto transaction history and identify which transactions are taxable and which aren’t. Then it’ll calculate your cost basis, capital gains or losses, and the fair market value of any crypto income on the day you received it.
Download your crypto tax report. Download the tax report you need, when you need it. Koinly can generate a huge variety of reports for tax offices around the world including the IRS, HMRC, the ATO, the CRA, and more.
Use your crypto tax report to file your preferred way. Hand your reports over to your accountant, upload your crypto tax report to your tax app, or file by post. The choices are endless.
Relax - you’re done for another year.
Get an exclusive 30% discount on your Koinly crypto tax report when you sign up to Koinly using code RARE30.
Disclosure
The information on this website is for general information only. It should not be taken as constituting professional advice from Koinly. Koinly is not a financial adviser or registered tax agent. You should consider seeking independent legal, financial, taxation or other advice to check how the website information relates to your unique circumstances. Koinly is not liable for any loss caused, whether due to negligence or otherwise arising from the use of, or reliance on, the information provided directly or indirectly, by use of this website.