The Ultimate DeFi Tax Guide

Disclaimer

CryptoTaxCalculator is not a registered accountant and does not know your individual case so cannot provide tax advice. This content was created for educational purposes but cannot be considered tax advice and is merely an interpretation of tax regulations. As always we recommend you check the regulations yourself or employ an accountant if you are unsure. This content was created in September 2020, with laws constantly changing in the crypto space this information might be out of date by the time you are reading this.

What is DeFi?

DeFi, short for decentralized finance, is the next big thing in crypto and for a good reason going after the global finance industry is no small task and the industry has some bold goals.

Decentralised finance is about taking the middleman out of the financial process, lowering costs, or increasing returns for consumers. Another way to look at it is that the consumer has control over their assets on the blockchain, they can lend them out, borrow against them or trade them without ever going through a financial institution.

From a technical perspective DeFi is a collection of digital assets, smart contracts, protocols and dApps built on the blockchain (mainly ethereum).

The Advantages and Disadvantages of using DeFi for taxes

DeFi solves a lot of interesting problems, some can be used to reduce your tax obligation while others have a lot of benefits but can inadvertently increase your taxes or need to file taxes.

Advantages:

1. Interest income from Lending: With the invention of cTokens to hold value, your interest can be classified as capital gains and not income, it also has the benefit that you can choose when to withdraw the tokens and pay the taxes rather than having the interest income airdropped to your wallet on a regular basis.

2. Rebalancing a portfolio: TokenSets allow you to hold a portfolio of crypto assets represented by a single token, this means that rebalancing your portfolio (which when normally done triggers a capital gains tax event) is done on the platform. As the amount of your Set tokens doesn’t change there is no capital gains obligation until you sell the underlying token.

3. Borrowing against long term holdings: Borrowing against crypto assets does not trigger any tax event, most countries reduce the capital gains obligation if you’ve held an asset for longer than 12 months. Borrowing against your assets can give you the benefit of short term capital without having to sell the underlying asset.

Disadvantages:

1. Depositing funds: Depositing on some DeFi platforms leads to minting new tokens. Platforms like Compound work on their own token which means when you deposit funds they are exchanged for a new token. this , just like any token to token transaction triggers a capital gain event.

2. Token distribution: Defi platforms have started creating their own governance tokens and distributing them to liquidity providers as a reward. This can present a problem if it was unexpected as an income tax event occurs based on the value when the tokens are distributed. For example, YFI is airdropped to your wallet when it is worth $1000, you decide to hold the token as an investment but when you finally sell it’s only worth $100, you can claim the loss as a capital loss but you will still owe income tax based on the token value of $1000.

Lending and borrowing

In the traditional financial system if you wanted a loan you would go to a bank, they would look at your income, assets and credit history and determine if you could get a loan and for how much. To fund your loan their capital would come from deposits.

In the new system there is no bank, if you have crypto assets you can lend them out to others yourself and if you want to borrow funds you can go to the same platform. It doesn’t mean you have to find the counterparty yourself, the platform will match the funds for you.

Exchanges

Looking at the current system again, if you want to buy a financial security you have to go through a centralized exchange, the NYSE, ASX etc. all buyers and sellers go through the central entity if they want to transact.

In a decentralized exchange traders can transact without giving control of their funds to another entity. You get privacy, security and control but in exchange you give up liquidity. As these exchanges are still growing liquidity is often lower than it would be for centralised exchanges. However if the bull run continues this might soon change.

How DeFi Taxes work?

Like all cryptocurrencies you have to be aware of the tax implications and this is often no small feat. Given how new the space is and how quickly it is changing most governments haven’t even come up with specific tax laws to cover all the cases yet. The best we can do is try to find any guidelines that might help us or compare the DeFi space to the rest of the crypto market which can have slightly more up to date regulations.

Lending

In Australia

The most straightforward case is when you lend in a crypto currency and are paid interest in that currency as well. For example, you lend 10 ETH at a rate of 10%, your interest is transferred to your account in ETH. In this case the interest earned is classified as ordinary income. You also have to be careful about who controls the funds when you are loaning. If you transfer the funds to a provider who takes control of the funds this could be considered a taxable event by the ATO as you are transferring your funds. One of the main ideas around DeFi is the control over your funds so this typically applies to traditional crypto lenders and not DeFi.

With newer DeFi lenders it can get a little trickier. Platforms like Compound have their own cTokens which they use to pay interest. When you make a deposit your balance will be visible in the currency you deposited but will actually be held in their cToken. In this case because there is another token involved it triggers a CGT event just like any other token swap would when you deposit and withdraw funds/ interest. This is certainly something to look out for when choosing a platform and filing your taxes.

In the US

Similar to Australia you are subject to tax on the interest you earn from your lending activities. The differentiating factor between income tax and capital gains also comes from the platform you use.

On platforms that use one currency to pay interest (you deposit BTC and are paid in BTC) You will be charged income tax as the interest will be classified as income. The dollar amount of income will be based on the current price of the currency you are being paid interest in.

On platforms that use their own token for lending and borrowing purposes (Compound) There is a token swap involved when you deposit and when you withdraw interest and as such you will be subject to capital gains tax.

Borrowing

In both Australia and the US the main advantage of using your crypto as collateral for a loan is that as long as you still control the funds this is not considered a capital gains tax event. However it is important to understand that transferring your funds to a third party to hold may be considered a loss of control and as such would be considered a crypto transfer and thus a capital gains event. If you are unsure, check the technical workings of the borrowing platform you are using.

Liquidity Pools

On DeFi exchanges you can provide liquidity to trading pools and in return you will be compensated with trading fees when a trade occurs for the pair you provided liquidity for. The income you receive is based on the trading fee the platform uses and the amount you have in the pool relative to the pool's size.

The main way liquidity pools work on DeFi platforms such as Uniswap and Balancer is that when you provide liquidity you receive liquidity pool tokens (LPTs) the amount of LPTs you have will remain the same but the value will increase based on the pools demand and trading fees. When you go to withdraw your liquidity it will be converted back into the original currencies you deposited and this represents a capital gain event.

Example: You deposit 1 ETH and 400 DAI into a Uniswap liquidity pool, in return you receive LPTs. As you are receiving a new token this can be considered a token swap and the price at which you acquired your LPTs will determine the cost base for the transaction. 3 months later you decide to withdraw your liquidity and receive 1 ETH and 450 DAI. The dollar sum of the 1 ETH and 450 DAI will be your sell price for the LPTs, the difference between the sell price and your buy price will be your capital gains/ loss.

Yield Farm Governance Tokens

Governance tokens are at the core of yield farming and have led to some of the wild APYs that have occurred over summer. Providing liquidity with platforms such as Compound or YFI users have earned governance tokens in the platform as a reward.

The governance tokens are used to help decide the issues in the platform and users can vote on the direction moving forward. They can also have huge value (YFI being close to $30,000 currently).

In both the US and Australia earning these tokens is subject to tax but income tax not capital gains tax. The tax owed is based on the value of the token at the time you receive it as a reward.

For example, you provide liquidity in the YFI platform and as a result, earn 1 YFI token. At the time the coin is airdropped to you it is worth $1000. The income tax you owe is based on the $1000. This price also determines your cost base. Let’s say you decide to hold the coin and sell a couple of weeks later for $30,000. Your capital gains on this transaction would be $30,000-$1,000 = $29,000.

TokenSets

A set is an ERC-20 token that represents a portfolio of assets. From a tax implication they have an advantage when it comes to portfolio rebalancing.

For example, you want to hold a portfolio of 50% ETH and 50% BTC, the price of ETH rises and now your portfolio is 60% ETH and 40% BTC, normally you would have to sell some ETH and buy BTC if you wanted to rebalance your portfolio, this would create a capital gain event as you are transacting between coins.

If you hold a set representing 50% ETH and 50% BTC the rebalancing won’t trigger a tax event.

For example, you hold 1 set token representing a portfolio of 50% ETH and 50% BTC, the same event occurs and now the portfolio is 60% ETH and 40% BTC. Instead of you having to rebalance it occurs on the TokenSet platform. The whole time you have held 1 set token. As this hasn’t changed there was no capital gains event.

The only capital gains event that will occur is when you buy and sell the set token.

WETH

A lot of DeFi platforms use WETH (wrapped ETH) rather than ETH to run the platform. This can lead to a tax event if you are depositing or withdrawing ETH. Some platforms automatically do this conversion for you when you deposit. As this is essentially a token swap (ETH for WETH or WETH for ETH) this will trigger a capital gains event every time it occurs.

Trading on a DEX

Trading on a DEX is fundamentally no different than trading on a centralised exchange in how you are subject to capital gains. Whenever you swap one token for another this triggers a capital gains event on the token sold and determines the cost base for the coin bought.

Crypto Lotteries

Gambling and lotteries generally have their own regulations and are typically not treated as standard income in most countries. However, as these lotteries involve crypto the regulations become less clear and as such should be treated as crypto transactions rather than traditional lotteries.

Pool Together is a great example, users deposit DAI to buy tickets into the lottery, the lottery fund earns interest, and users are given back their funds with one user winning the interest at the end.

This presents a problem as Pool Together takes control and ownership of your funds during the holding period so they can earn interest. This means that when the funds are airdropped back to you they are subject to income tax if treated as a standard crypto transaction. Even your initial deposit will incur an income tax at the value of the DAI when it is returned to you.

Margin Trading

Unfortunately, the ATO has provided little guidance on how to handle margin trading but based on US regulations one interpretation could be that borrowing the crypto itself is not a taxable event while the gains/ losses on the trade are treated as a capital gains event.

If a margin call occurs that results in closing out your position this can be treated as a loss on the trade and the liquidation is when the sale occurred.

Top DeFi Protocols

Aave: aTokens are minted when you deposit assets to the Aave protocol, unlike other DeFi tokens aTokens are pegged to the underlying asset e.g. aDai is equal to Dai. This leads to 3 separate tax events if you are lending through Aave.

1. When you deposit funds they are exchanged for the corresponding aToken so this is a capital gains event for the sale of the original asset.

2. When you earn interest you accumulate aTokens which is an income tax event.

3. When you sell your aTokens this is another capital gains event.

Compound: As mentioned previously cTokens increase in value rather than accumulating tokens so this is classified as a capital gains event. In this case, there would be two capital gains events when you lend to generate interest on Compound.

1. When you deposit funds to Compound you are exchanging them for cTokens, as this is a token to token transaction and you are selling the original coin this is a capital gains event.

2. When you withdraw your cTokens and sell them back to the original currency this is another capital gains event.

Yearn Finance YFI was distributed to liquidity providers using the Yearn.finance protocol in July as this was a new token and was airdropped the tax here would be income tax with the value being equal to the price of the token when it was given to you. If you hold the token and sell it later you also incur a capital gains tax where the cost base is the initial value of the airdrop.

Maker There are two main things you can do on Maker from a tax perspective, trade and save Dai. Trading is standard in terms of crypto taxes and each trade is subject to capital gains. Saving Dai on the other hand earns Dai as interest, as interest is paid in more tokens and not an increase in value in the token you already have. This is considered an income tax event.

1inch Exchange 1inch is a decentralized trading aggregator to find you the best price, from a tax perspective 1inch is nothing different from other DEXs and again the main tax is capital gains on every trade you make.

Balancer Balancer is a DEX like Uniswap with the same two main functions, trading and providing liquidity. Trading on Balancer is subject to standard crypto trading taxes. Providing liquidity is similar to Uniswap but slightly different from a tax perspective.

When you provide liquidity your tokens are converted to Balancer Pool Tokens (BPTs) which represent your share of the liquidity pool. As you earn your fees the value of your BPTs increase and when you withdraw you will be subject to capital gains. Bal is also distributed to all liquidity providers on a regular basis, as this a separate token and airdropped to you it is subject to income tax based on the value when airdropped.

Things To Keep In Mind

As DeFi is a constantly evolving landscape with new protocols and assets appearing daily the regulators are struggling to keep up. There are a few growing areas that still don’t have any specific tax laws and thus it is better to use the traditional crypto tax laws surrounding buys, sells, deposits and withdrawals. Specifically predictions markets, insurance contracts and derivatives lack sound regulation at this time so it is better to keep these general tax rules in mind:

1. If you exchange one token for another this is a capital gains event, this includes wrapping tokens and cTokens.

2. If you transfer your tokens to a platform that takes ownership or control of your funds this means technically speaking you no longer hold those funds.

3. If you are airdropped tokens or earn tokens in a staking manner you have to pay income tax based on the value of the tokens at the time of the airdrop and if you hold the tokens you also have to pay capital gains with the cost base being the value at the time of the airdrop.

How CryptoTaxCalculator Can Help

As you can see there are a lot of different rules depending on what you are doing in the DeFi space. However no matter what you are doing you have to keep a record of it for tax purposes and calculate the tax you owe based on each transaction. If you are doing more than one thing in the DeFi space or doing a lot of transactions it can become a painstaking process. This is where CryptoTaxCalculator can help. Not only will we unify your records from all your crypto accounts and platforms but we make the tax calculation process easy.

All you have to do is upload your transactions by API or CSV, check they are classified appropriately (buy, sell, stake, airdrop) and we will take care of the rest.