DeFi taxes are a rapidly evolving area of cryptocurrency regulation. DeFi, or decentralized finance, refers to blockchain-based financial services like lending, trading, and staking. It is often conducted across multiple wallets and platforms without intermediaries.
Tax treatment of DeFi transactions remains unclear in some cases and may change as Internal Revenue Service (IRS) guidance evolves. Given the complexity of staying on top of a developing regulatory framework, partnering with a crypto-savvy CPA is essential for staying compliant and optimizing your tax position.
DeFi Tax Treatment Explained
DeFi activity is subject to several different tax treatments. Capital gains tax and ordinary income tax are the most common. The nature of your transaction and when it occurs will impact the tax classification and the rate you pay.
DeFi is characterized by complex and anonymous transactions. Furthermore, some DeFi transactions like liquidity pool deposits or withdrawals fall into legal gray areas and are subject to interpretation until clearer IRS guidance is released.
Though DeFi’s complexity makes tax reporting more difficult to understand, it doesn’t make it exempt from accurate and timely reporting. Understanding how different transactions trigger taxable events with help from an expert in crypto CPA services is the best way to stay compliant and avoid costly penalties down the line.
Common DeFi Transactions and Their Tax Treatment
The DeFi ecosystem is known for its complexity as transactions often involve multiple steps and transfers between different wallets. This makes accurate record-keeping a must, as every transaction—including purchases, sales, swaps, deposits, and transfers—must be recorded on your tax return.
Remember, the IRS considers cryptocurrency property, not currency. Therefore, capital gains tax applies to any increase in the price of the crypto you sell (or dispose of in any way) compared to its cost basis. Crypto that has depreciated by the time of sale counts as a capital loss. Losses can be used to offset any other crypto gains you make to reduce your overall tax liability.
A CPA with experience in cryptocurrency taxes will take you through the process of reporting the following transaction types correctly:
Swapping Tokens
Swapping one cryptocurrency for another is a taxable event, as the crypto you’re giving up is treated as sold. Any gain or loss is then calculated against its cost basis. Gas fees paid in crypto may result in capital gains if the token used has appreciated.
Fees may be added to the cost basis of the new asset or deducted from proceeds, depending on the transaction. Conversely, paying for gas using appreciated crypto triggers capital gains tax.
Receiving Token Rewards
Token rewards are the result of activities like staking, airdrops, or yield farming. Rewards gained from these activities are treated as ordinary income. Tokens earned through DeFi-based games are also treated as ordinary income.
All of these tokens (including rewards and earnings) are subject to regular income tax rates, based on their fair market value at the time of each transaction.
Selling Token Rewards
Selling token rewards at a profit triggers capital gains tax. Calculating what you owe involves calculating the asset’s fair market value and subtracting the cost basis.
You’ll pay long-term capital gains tax if you’ve held the asset for more than a year before selling. Assets held for less than a year will be treated as a short-term capital gain, taxed at ordinary income tax rates.
Staking Rewards
Staking DeFi involves setting aside an amount of your crypto to help maintain a blockchain system’s operations. You could think of it as saving money in a bank to earn interest, but you’ll receive tokens rather than interest in return for your stake.
Rewards you receive from staking are currently taxed as ordinary income. Cases like Jarrett vs United States have sought to establish clear precedents, but so far none have been set. Similar cases in the future could result in more definitive guidance.
Liquidity Pools
Liquidity pools on DeFi platforms provide a way for users to pool their crypto assets to facilitate activities like trading and lending. This activity has multiple stages that trigger different taxable events:
- Depositing crypto into a liquidity pool may be treated as a taxable disposal. However, this will depend on how the protocol is structured and whether you maintain control over the assets.
- The rewards you receive from the pool are then considered taxable income.
- Another capital gains tax event is triggered when the user returns their liquidity pool token and receives crypto.
Airdrops
DeFi projects use airdrops to reward loyal users, distribute governance tokens, or promote a new feature. Airdrops are considered taxable income, whether you opted to receive them or not.
For the taxpayer, this means recognizing income at the token’s FMV on the date you can access, control, and transfer the tokens. Selling airdropped tokens will then trigger capital gains.
DeFi Loans
Taking out a loan while using your crypto as collateral generally isn’t considered a capital event. If your loan is liquidated and the protocol sells your collateral, this is considered a taxable disposal and may trigger capital gains or losses.
Earning interest through lending crypto is taxed as ordinary income. Furthermore, interest payments you make on loans may be deductible when the loan was taken for business or investment purposes.
DeFi Tax Reporting: What You Need to Know
Reporting taxes on DeFi transactions is an intricate and often complex process due to their decentralized, fast-moving, and often anonymous nature.
The IRS published its final regulations on reporting digital asset transactions in June 2024. These rules require brokers to report gross proceeds of digital asset transactions via Form 1099-DA, to be introduced in 2026 for the 2025 tax year. Full third-party reporting for DeFi exchanges using Form 1099-DA will be mandatory from 2027 for transactions completed in 2026. This puts the onus on brokers and individual taxpayers to track, calculate, and report gains, losses, and income correctly.
Tip: Working with a CPA with proven experience in working with DeFi taxes is the best way to keep your records in order and avoid any issues related to compliance or tax evasion.
Every Transaction Could Be a Taxable Event
Every DeFi interaction is potentially a taxable event. Keep meticulous records of all your transactions to stay compliant and ensure you claim all the deductions to which you’re entitled.
Keep detailed records of the date, transaction type, the token involved, the fair market value at the time, and the gains or income realized. Sound record-keeping also extends to the wallets you use and will be invaluable in the case of an IRS audit. Keep records of:
- Any wallet addresses and ownership
- The protocols used and when
- Token prices at the time of the transaction
- Gas fees (these may be deductible)
Track Your Cost Basis
Tracking the cost basis of your crypto assets is essential for calculating capital gains or losses when you dispose of an asset. This is tricky if you frequently swap tokens, earn rewards, or receive liquidity pool tokens. However, proper tracking is a must. Not doing so puts you at risk of overpaying taxes or underreporting gains; both of which leave you open to audits or penalties.
Separate Capital Gains and Income
DeFi taxes fall into two categories: capital gains and ordinary income. You must distinguish between the two and understand the transactions that trigger one or the other:
- Capital gains (or losses): Selling, swapping, or disposing of crypto assets results in capital gains tax. Report capital gains or losses on Form 8949 and Schedule D.
- Ordinary income tax: Ordinary income tax is triggered when you receive new tokens through yield rewards, airdrops, or staking. Use Schedule 1 for occasional income and Schedule C if you’re regularly earning crypto as part of a trade or business.
Remember that losses also open up the opportunity to engage in crypto tax-loss harvesting. Ask your CPA how to sell depreciated assets strategically to offset other income.
Leverage Crypto Tax Software
Tracking DeFi activity is complicated, especially if you use multiple wallets and protocols. Crypto tax software is a useful tool to categorize transaction data and generate tax reports. Using software and working with a CPA with expertise in crypto tax reporting will keep you compliant and ensure you receive the most favorable tax rates.
Report Worldwide Crypto Income and Gains
The IRS requires U.S. taxpayers to report worldwide crypto income and gains. It’s wise to stay on top of your obligations, as the burden of reporting for tax purposes falls entirely on the taxpayer.
Take Control of Your DeFi Tax Obligations
Navigating DeFi taxes requires careful record-keeping, an understanding of taxable events, and awareness of the latest IRS guidance. As DeFi continues to grow and evolve, so too will the rules surrounding its tax treatment.
Keep meticulous records, use reliable crypto tax software, and consult a CPA experienced in digital assets to stay compliant and minimize risk. With expert support and accurate tracking, you will meet your obligations confidently and take full advantage of legal tax strategies.
