Do you have DeFi profits? The IRS wants its cut by April 18, 2022. Don’t panic — we unravel everything you need to know about the crypto tax in our guide.
The IRS has made it very clear that you must pay taxes on your crypto and report crypto gains and earnings on your annual income tax return. However, what is less clear is exactly how some DeFi crypto transactions will be taxed. The IRS guidance hasn’t been updated since 2019, so while it covers the basics, it has left recent market developments — like DeFi and NFTs — shrouded in mystery.
But don’t think you’re off the hook! There is enough evidence to deduce the tax implications of DeFi in the US. Head of Tax, Tony Dhanjal at Crypto Tax Calculator Koinly, spills the tea.
DeFi Tax Bases
DeFi tax received complicated. It all depends on how the specific protocol you are using works.
Buy, trade or sell on indices? Light. Follow the same capital gains tax rules as for any other crypto coin or token.
Staking, Liquidity Mining, Yield Farming or Lending? Whatever you plan to do – the taxes you will pay will depend on how your specific protocol works, it could be subject to capital gains tax or income tax. It all boils down to whether you earn new tokens or if the price of your token increases.
Let’s take a look at some different examples from common protocols and how they are taxed.
Liquidity Pool Taxes
Liquidity pools are essentially broken down into three transactions, each of which can be taxed differently:
- add liquidity
- remove liquidity
- Realizing a profit or earning new tokens.
You might think that adding and removing liquidity from a given pool is tax-free, but due to liquidity pool tokens, it’s not quite that simple. In return, when you add liquidity to a given pool, you receive LP tokens, which represent your capital in the pool. Similarly, if you wish to remove your equity, exchange your LP tokens back for your equity.
From a tax perspective, this could be considered a crypto-to-crypto trade – meaning that this transaction realizes a capital gain or loss and is subject to capital gains tax.
When it comes to making money from liquidity pools, it all depends on how your specific liquidity pool works, so we’ll use a few examples.
For example, let’s say you added liquidity to a pool on PancakeSwap. In return, you receive liquidity pool tokens that represent your share of the pool, and you receive a percentage of the transaction fees as a reward. However, your rewards will not be paid out in the form of new tokens. Instead, the value of your LP tokens will increase. Only when you withdraw your capital from the pool do you realize a profit. This example is more like a capital transaction, and you pay capital gains tax on any gain at the point you realize it. All other protocols that work this way are subject to the same tax treatment.
Now let’s say you want to add to a composite credit pool instead. As above, you will receive cTokens representing your equity in the loan pool and these cTokens will increase in value as you earn them. So adding and removing liquidity (and some of your rewards) would still be subject to capital gains tax when you transfer capital – as above. However, you also get COMP tokens. You earn new COMP tokens that you can claim at any time. As you earn new tokens, this is viewed more as a type of additional income and you pay income tax based on the fair market value of your tokens at the time you received them.
What about staking, how is it taxed?
Staking can refer to two different activities in the DeFi space – although they are both similar from a tax perspective.
If you are staking under a proof-of-stake consensus mechanism – for example if you are staking ADA, AVAX or SOL – it is likely that you will have to pay income tax based on the fair market value of all staking rewards at the time you are staking receive them. However, this is currently challenged in courtso that the tax treatment of the stake could change in the future.
Meanwhile, if you stake tokens in different DeFi protocols to earn more rewards – like liquidity pools – it all depends on how your specific DeFi protocol works.
SushiSwap is a great example of both types of taxes you can pay. For example, you can use your SLP tokens and KMP tokens to earn SUSHI tokens. If you earn new SUSHI tokens, you will have to pay income tax based on the fair market value of your SUSHI tokens (in USD) at the time of receipt.
You can then use your SUSHI tokens at the sushi bar to earn XSUSHI. However, if you wager your SUSHI tokens, you will receive XSUSHI tokens in return. XSUSHI – like SLP and KMP tokens – accrue in value. So you will only realize a profit when you deposit your SUSHI by exchanging your XSUSHI tokens back. This would be more of a trade and therefore you will instead pay capital gains tax on any profits made from trading your SUSHI tokens, both when you wager and when you remove your wager.
Income taxes for agriculture
Income tax – as above – all depends on how your specific DeFi protocol works.
For example, if you use the Inari Yield Farming protocol on SushiSwap, then you are effectively trading SUSHI for XSUSHI – even if your SUSHI is then lent out through different protocols to generate returns. This would be considered crypto trading and all profits are subject to capital gains tax.
Meanwhile, if you use PancakeSwap to stake LP tokens to earn PIE (or even stake this PIE to earn more PIE or tokens), then you will earn new tokens as a result of your activities. This is viewed more as additional income, so you would pay income tax based on the fair market value of your tokens at the time of receipt.
NFT tax
As a little bonus, we’re including NFTs here because the rules are just as muddy as DeFi. From a tax point of view, NFTs are not too different from other tokens. They’re still considered a form of property, and if you dispose of NFTs through sale or trade, you’ll pay capital gains tax on any profit you make.
However, we add a caveat here that the tax treatment of sold NFTs depends on whether you transacted the NFT. If you create and sell NFTs (like a regular artist with a paintbrush), you pay income tax instead.
There is also a possibility that in the future the IRS may decide to tax some NFTs at the special collector tax rate of 28% instead of the maximum long-term capital gains tax rate of 20%.
Wait, isn’t anything tax free?
The IRS will save you on taxes on a few occasions, including:
- Buy crypto with USD.
- Transfer crypto between your own wallets.
- HODLing crypto.
- Giving away crypto (although if it’s valued at more than $16,000, you’ll need to file a 709).
- Donate crypto to a registered charity.
How to calculate, report and file your DeFi crypto taxes in 5 steps
Now learning how it is taxed, you can see how much of a hellscape crypto tax reporting is. We’re not even getting to the worst, because not only does the IRS want a snip on your crypto profits and earnings — the reporting requirements are high, too.
You must report every single one Disposal of crypto on Form 8949, your net capital gain and loss on Schedule D, any income from crypto on Schedule 1 and add all of this to Form 1040. It should go without saying, but for investors involved in DeFi, there are potentially thousands of transactions that they need to report.
Save yourself hours of pain, use Koinly Crypto Tax Calculator and follow these 5 easy steps to file your crypto taxes instead:
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- Connect all your wallets, exchanges and blockchains to Koinly. You can do this via the API or by importing CSV files of your transaction history.
- Grab a coffee and let Koinly do his job. Koinly compiles your entire crypto transaction history and identifies which transactions are taxable and which are not. Then it calculates your cost basis, capital gains or losses and the fair market value of all crypto earnings on the day you received them.
- Download your crypto tax report. Download the tax report you need, when you need it. Koinly can generate a variety of reports including Form 8949 and Schedule D, TurboTax online reports and our full tax report with everything you need to know about your crypto taxes.
- Use your crypto tax report to submit your preferred method. Hand your reports to your accountant, upload your crypto tax report to your tax app, or live in the 1990s and submit it by mail. The choices are endless.
- Relax – you’re done for another year.
That’s it – you’re done. If you want to learn more about the crypto tax, check out Koinly’s Ultimate US Crypto Control Guide.
disclosure
This post was commissioned by Koinly. This report is for informational purposes only and should not be relied upon for making investment decisions, nor is it offered or used as legal, tax, investment, financial or other advice. You should do your own research and consult independent legal counsel on the matters discussed in this report. Past performance of an asset is not indicative of future results.
© 2022 The Block Crypto, Inc. All rights reserved.
© 2022 The Block Crypto, Inc. All rights reserved. This article is for informational purposes only. It is not offered or intended to be relied upon as legal, tax, investment, financial or other advice.
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