How to Pay Defi Taxes

DeFi stands for “decentralized finance.” It is a system of financial applications built on a blockchain that aims to provide an open, permissionless, and transparent alternative to traditional financial systems. DeFi protocols allow users to lend, borrow, trade, and exchange cryptocurrencies, and other digital assets in a decentralized and trustless way, without relying on intermediaries such as banks or financial institutions. Examples of DeFi applications include decentralized exchanges, lending platforms, stablecoins, and more.

DeFi presents a vast array of investment opportunities, with a total value locked in DeFi protocols estimated at around $96.3 billion. There are numerous ways to make money from DeFi protocols, with the most popular being staking, yield farming, liquidity mining, and advanced trading, such as derivatives and futures.

Staking: Investors can stake their assets into a protocol, and receive fees in return. For example, users can stake tokens in Polkadot, and earn an annual percentage yield. Dedicated staking protocols, like Lido and StakeHound, also exist.

Yield Farming: Similar to staking, yield farming involves depositing assets into a protocol to earn rewards. Some yield protocols automate this process, such as Curve and Convex Finance, while others require investors to engage in research by finding the protocols with the highest yield, and utilizing strategies such as “compounding” – reinvesting earned rewards back into the protocol to earn more rewards and maximize returns by staking different protocols. Investors can research the best protocols for yield farming by considering several factors, including the protocol’s reputation, security, liquidity, fees, and potential returns. They can use various resources such as decentralized finance (DeFi) data aggregators, analytics platforms, and forums to compare and analyze different protocols. Additionally, investors can also review the protocol’s whitepapers and smart contract code to understand how it works and assess its security.

Liquidity Mining: Liquidity mining refers to adding liquidity to DeFi protocol pools for rewards, usually in the form of the protocol’s native token, like CAKE or UNI. Some of these tokens have seen significant growth in value, making them desirable to investors.

Play-to-Earn DeFi Games and Gamified DeFi: Investors can earn tokens by playing DeFi games, such as Axie Infinity, Dencentraland, and Coin Hunt World. DeFi protocols are also gamifying DeFi, with DeFi Land being a prime example. Players can farm tokens and earn an annual percentage yield through these accessible and appealing games. The play-to-earn model has also evolved into the play-to-watch DeFi model, with Brave’s BAT as an example.

Derivatives and Margin Trading: Decentralized exchanges offer various advanced trading opportunities, including futures, options, and margin trading. These carry both high risks and rewards, and are not suitable for everyone. While some experienced investors have found success, many others have not.

The tax implications of DeFi investments are complex and often unclear, as the decentralized nature of DeFi implies there is no central authority or regulatory body to provide guidance. However, DeFi investments are subject to the same tax rules as traditional investments. Thus, any profits or gains that investors make from DeFi investments are taxable, just like they would be if they had invested in stocks, bonds, or other financial instruments.
Cryptocurrencies are treated as property for tax purposes in the U.S. and many other countries. If investors engage in DeFi activities, they may incur capital gains and income tax liability. Capital gains occur when investors sell, exchange, or dispose of their cryptocurrency. On the other hand, ordinary income is recognized when investors earn cryptocurrency through mining, staking, or various forms of interest. The fair market value of the cryptocurrency at the time of receipt determines the income recognized.
At present, the IRS has not released any direct guidance on DeFi taxes, but the tax implications for DeFi can be inferred from general cryptocurrency tax guidelines. In the United States, the infrastructure bill signed by President Biden in November 2021 requires any party that facilitates a cryptocurrency transaction to provide 1099 tax reporting information to the user and the IRS. However, it’s not yet clear whether these requirements will apply to DeFi protocols, which are decentralized and may not have the capability to send 1099s. The crypto provisions of the bill do not take effect until January 2024, and it’s expected that crypto companies will lobby against the bill in the courts until then.
It’s important to note that the tax implications of DeFi investments can vary depending on the investor’s jurisdiction, so it’s important to research the specific tax laws in the area.

The first step in paying DeFi taxes is to calculate the taxable income. This will depend on a number of factors, including the type of DeFi investments made, the length of time that the investor has held the investment, and the specific tax laws in the investor’s jurisdiction.

For example, when an investor lends cryptocurrency out, they are liable to pay taxes on any income that they receive as a result of the lending activity. The profits derived from this activity will probably be classified as either capital gains or ordinary income, based on the character of the specific transactions. If an investor has invested in yield-generating DeFi protocols like Compound, they will need to calculate the amount of interest earned over the course of the year. This can be done by using DeFi tax calculators such as TokenTax, ZenLedger, Koinly etc., which can help estimate the taxable income based on investment history.

Another important factor to consider when calculating DeFi taxes is the tax rate that the investor will be subject to. Tax rates for DeFi investments are typically based on the overall taxable income, and can vary from country to country. For example, in the United States, the tax rate for long-term capital gains (investments held for over a year) is typically lower than the rate for short-term capital gains (investments held for less than a year).

Popular DeFi platforms and an overview of their tax treatment

Uniswap

Uniswap is a decentralized exchange platform founded by Hayden Adams in 2018 that operates on the Ethereum blockchain. Its unique structure, built on the concept of an automated market maker outlined in a blog post by Vitalik Buterin, has made it one of the largest and most popular decentralized exchanges.

Uniswap Tax Treatment:

Liquidity tokens: These allow liquidity providers to deposit their cryptocurrency holdings into a liquidity pool. In exchange, they receive Liquidity Provider (LP) tokens that represent their position within the pool. As the pool grows in value from trading fees, liquidity providers can claim their share by cashing in their LP tokens. It’s important to note that adding or removing liquidity from the pool incurs a taxable event, and generates a capital gain or loss based on the change in the value of the asset since it was received.

Airdropped UNI tokens: These are considered taxable income based on their fair market value at the time of receipt. If these tokens are sold, a capital gain or loss will be incurred based on the change in their value since receipt.

Uniswap V3: These take a different approach by giving liquidity providers an NFT that represents their position in the liquidity pool instead of LP tokens. Liquidity providers can trade their NFT for their share of the LP pool at any time, and it’s advisable to report this as a taxable event and incur a capital gain/loss based on the value change of the asset since it was received.

Compound

Compound is a protocol that allows users to either lend or borrow crypto assets. By depositing crypto into a chosen lending pool (e.g. ETH, DAI, BAT), users receive a cToken that represents their deposit and accrues interest. Instead of paying out more cTokens, the cToken increases in value relative to the underlying asset. When withdrawing, the user trades the cToken back. Borrowing follows a similar process, requiring collateral in the form of cTokens. Additionally, Compound has a dual-token system where users earn COMP tokens for lending and borrowing, which gives them voting rights on protocol proposals. COMP has a current value of $50 but has previously reached a high of $900.

Compound Tax Treatment:

Lending/Borrowing: Lending crypto on Compound results in receiving cTokens, which could be considered a crypto-to-crypto trade, and subject to Capital Gains Tax. Borrowing requires collateral, and the exchange of assets for cTokens could also be seen as a crypto-to-crypto trade subject to Capital Gains Tax.

Interest: With Compound, interest is represented by the increase in value of cTokens in relation to the underlying asset. This is not considered income, and gains are only realized when cTokens are traded back, making it a crypto-to-crypto trade and subject to Capital Gains Tax.

COMP Tokens: Earned by lending and borrowing on Compound, COMP tokens are considered income and subject to Income Tax based on the fair market value at the time of receipt.

Curve

Curve Finance is a well-regarded DeFi platform that sets itself apart from others by prioritizing stability and composability over volatility and speculation. A few of the ways it stands out include:

• Its market-making algorithm provides more market depth for the same total value locked, making it appealing for traders and liquidity providers.
• Unlike traditional market makers, Curve Finance offers liquidity to customers with assets supported by its markets.
• The platform is transparent about the risks involved, with the official website advising users to research the potential dangers before making a deposit.
• The liquidity pool on Curve allows for seamless token transactions between categorized pairs, with low trading fees of 0.04% per transaction due to its direct swap feature.

Curve Finance and Taxation

Stablecoins: Despite being created specifically for transactions, stablecoins are taxed like other cryptocurrencies. Thus, investors must report any disposals of stablecoins on their tax return, although the capital gain is likely to be close to 0. Capital gains tax applies to the trading of stablecoins on Curve.Fi.

Liquidity pools: There is currently no clear guidance from the IRS on how liquidity pools should be taxed. As a result, there are different strategies that investors can follow based on their risk tolerance. A conservative approach is to view depositing cryptocurrency into a liquidity pool as a taxable crypto-to-crypto swap. An aggressive approach is to consider this as a non-taxable deposit.

Once an investor has calculated their taxable income, the next step is to pay DeFi taxes. The exact process for paying DeFi taxes will depend on the jurisdiction, but here are some general guidelines:

Report DeFi investments on tax return

In most cases, investors will need to report their DeFi investments on the tax return, just like any other investment. This will typically involve filling out a form that provides information about the investments, such as their value and the dates on which the assets were bought and sold.

For most crypto traders, they only need to transfer information from IRS Form 8949 to Schedule D, which is the same schedule used for reporting stock sales. Some additional tax return sections that might apply to crypto investors are:

Schedule 1: Gifts (such as airdrops) or income from forks or hobby activities must be reported as other income on line 8 of Schedule 1.

Schedule B: Investors who receive interest or rewards from lending or staking must report their investment income on Schedule B. Typically, this information would be found on a 1099-INT or 1099-DIV statement, but Coinbase provides it on a 1099-MISC.

Schedule C: Investors who mine cryptocurrency may be eligible for tax deductions. It is necessary to declare all mining operations on Schedule C. If a miner receives a 1099-MISC related to this activity, their income can be reported using it, but most miners will need to use a tool to convert their mining activity into US Dollars.

Preparing a DeFi tax report can be daunting unless one is aware of the right tools. Some of the best DeFi tax support software are as follows:

TaxBit: Top Overall Solution

TaxBit is the only firm that provides free DeFi (Ethereum protocols) support and generates tax reports based on transaction history for free. For those who require additional assistance, TaxBit also offers premium support levels such as concierge support for CSV imports, and an annual review by a CPA.

TokenTax: Comprehensive Service Provider

TokenTax is a full-service cryptocurrency tax software company that specializes in DeFi, and other challenging crypto matters. It is an excellent choice for NFT investors and those with DeFi transactions, although it comes at a high cost. Its base plan comes for $65 per tax year but the more comprehensive solution for advanced investors comes for $3499 (approximately) per tax year.

ZenLedger: Excellent Value Offer

ZenLedger provides DeFi support starting from its $149 premium tier, and has seamless integrations with TurboTax, making it a cost-effective and top-quality option.

Koinly: Cost-Effective for Small-Volume Traders

Koinly provides DeFi support at all pricing levels, including the budget-friendly $49 newbie tier, and also supports taxes for algorithmic traders with over 500,000 yearly transactions.

Pay the appropriate tax

Once an investor has reported their DeFi investments on the tax return, they will need to pay the appropriate tax. This can be done by writing a check or making an electronic payment to the tax authorities in the jurisdiction. There are several online payment options for DeFi taxes, including:

Bank Transfer: This is a simple and straightforward option where an investor can transfer funds from their bank account to the tax agency’s account.

Credit/Debit Cards: Many tax agencies accept payment via credit or debit cards, either online or through a phone payment system.

Digital Wallets: Some tax agencies accept payment through digital wallets such as PayPal, Venmo, or Apple Pay.

Cryptocurrency: Some tax agencies accept payment of taxes in cryptocurrencies such as Bitcoin, Ethereum, or Litecoin.

DeFi Protocols: DeFi protocols such as Uniswap may also be used to pay DeFi taxes. In this case, an investor would need to transfer funds to the DeFi protocol, convert them to the required cryptocurrency, and then make the payment to the tax agency.

There are several jurisdictions or tax authorities that accept crypto payment for taxes. Some examples include:

Switzerland: The Swiss government allows individuals and companies to pay taxes with Bitcoin and Ether.

Ohio, USA: Ohio became the first U.S. state to accept Bitcoin for tax payments in 2018.

Arizona, USA: Arizona allows taxpayers to pay income taxes using cryptocurrencies.

Slovenia: In Slovenia, individuals and businesses can pay income and corporate taxes with Bitcoin.

It’s important to note that the acceptance of crypto payments for taxes is still a relatively new development and is subject to change. It’s recommended to check with the relevant tax authority for the most up-to-date information.

Keep records

It’s important to keep accurate records of DeFi investments and any taxes that have been paid. This will help in case of an audit, and will also make it easier for the investors to calculate taxable income in the future.

Tax laws and rates related to cryptocurrency vary significantly between different countries. Here is a brief overview of the tax laws in several countries:

United States: In the US, cryptocurrencies are treated as property for tax purposes. Thus, capital gains tax is applied to any profits made from selling or exchanging cryptocurrencies, and losses can be used to offset gains. The tax rate on short-term capital gains (assets held for less than a year) ranges from 10% to 37%, depending on the individual’s income. Long-term capital gains (assets held for over a year) are taxed at a lower rate of 0%, 15%, or 20%, depending on income.

United Kingdom: In the UK, cryptocurrency is also considered a form of property for tax purposes. Capital gains tax is applied to any profits made from selling or exchanging cryptocurrencies. The tax rate on capital gains is 10% or 20%, depending on the individual’s tax bracket.

Canada: In Canada, cryptocurrency is taxed as a commodity. Thus, any profits made from buying and selling cryptocurrencies are treated as business income or capital gains, depending on the frequency and intention of the trades. The tax rate on business income is the same as the individual’s income tax rate, while capital gains are taxed at 50% of the individual’s income tax rate.

Australia: In Australia, cryptocurrency is treated as property for tax purposes. Capital gains tax is applied to any profits made from selling or exchanging cryptocurrencies. The tax rate on capital gains varies depending on the individual’s income, and whether the asset was held for more or less than a year.

Germany: In Germany, profits from cryptocurrency trading are subject to income tax. The tax rate ranges from 14% to 45%, depending on the individual’s income.

It is important to note that tax laws and rates can change over time and may vary depending on individual circumstances. It is recommended that individuals consult with a tax professional for specific guidance on how cryptocurrency is taxed in their country or jurisdiction.

DeFi or decentralized finance has become a significant part of the crypto world with an estimated $96.3 billion locked in various DeFi protocols. There are many ways to earn from DeFi such as staking, yield farming, liquidity mining, play-to-earn games, and advanced trading. While DeFi offers many investment opportunities, it also comes with tax implications that are often unclear. In general, DeFi investments are subject to the same tax rules as traditional investments, and are treated as property for tax purposes in many countries. The first step in paying DeFi taxes is to calculate the taxable income, which will depend on factors such as the type of investment, the length of time held, and the specific tax laws in the jurisdiction. Tax rates for DeFi investments vary from country to country and it’s important for an investor to research the specific tax laws in their area, and consult with a tax professional if they have any questions or concerns. With DeFi activities growing, investors should be aware of the tax implications, and take the necessary steps to ensure they are in compliance with the law.