- DeFi investors and participants need to pay ordinary income tax or pay capital gains tax on all crypto transactions, depending on the transaction type.
- By working with a tax advisor, DeFi participants can leverage tax-loss harvesting, long-term capital gains, and tax-advantaged accounts to reduce their tax bill.
- The IRS is continuously evolving DeFi tax guidance and will likely implement new forms, including Form 1099-DA in the coming years.
An Introduction to DeFi
Decentralized Finance (DeFi) is a rapidly evolving space. It offers blockchain-based financial applications that enable individuals and businesses to access various financial services, including lending, borrowing, trading, and earning interest, without traditional financial institutions as intermediaries. All of these activities occur on platforms called DeFi protocols. By leveraging smart contracts and decentralized networks, DeFi aims to create an open, transparent, and accessible financial system.
In this guide, we will explore a variety of use cases for DeFi and their associated taxes, including:
- Token Swaps
- Staking
- Lending and Borrowing
- Yield Farming
- Liquidity Pools
- Non-Fungible Tokens (NFTs)
- Governance Tokens
- Decentralized Autonomous Organizations (DAOs)
- Tax Code Changes for DeFi in 2024
- Relevant IRS Tax Forms for DeFi Taxes
- Minimizing Taxes on DeFi Transactions
Understanding these concepts and applications will help you better navigate the DeFi ecosystem, especially regarding any tax liabilities you may incur when participating in DeFi transactions. If you’d like to learn more about DeFi taxes as it relates to your personal situation, contact a Harness Tax Advisor today.
Overview of DeFi Use-Cases and Their Tax Implications
Before diving into specific tax implications, it is essential to understand the various DeFi use cases and their potential tax consequences. Here are some of the most common:
Token Swaps
Token swaps involve exchanging one cryptocurrency or crypto asset for another on decentralized exchanges (DEXs) or through automated market makers (AMMs). These swaps are treated as taxable events, similar to traditional crypto-to-crypto trades. The difference between the fair market value of the acquired asset and the cost basis of the disposed asset is subject to capital gains tax.
An example of a token swap is exchanging Ethereum (ETH) for Chainlink (LINK) on a decentralized exchange (DEX) like Uniswap, which uses an automated market maker (AMM) mechanism to facilitate the trade.
Staking
Staking involves locking up tokens in a smart contract to participate in network validation and earn rewards or financial compensation. Staking rewards are considered taxable income at the time of receipt, and their fair market value should be reported as income on your tax return. The cost basis of the staked tokens remains unchanged, and any capital gains or losses will be realized when the tokens are eventually sold or exchanged.
One example of a staking platform is Avalanche (AVAX), which partnered with Amazon to power blockchain infrastructure for government, enterprise, and institutional users of Amazon Web Services (AWS).
Lending and Borrowing
DeFi platforms, such as AAVE, enable users to lend and borrow crypto assets. When lending assets, the interest earned is considered investment income and is subject to ordinary income tax. Borrowing, on the other hand, similar to traditional cash loans, does not trigger a taxable event unless the borrowed funds are used to acquire more crypto assets. In that case, the transaction would be considered a margin trade and may have tax implications based on capital gains or losses.
Yield Farming
Yield farming is the process of providing liquidity or staking assets in DeFi protocols to earn rewards, often in the form of governance tokens. Yield farming can result in taxable income in the form of governance tokens or other rewards. These rewards must be reported as income based on their fair market value at the time of receipt.
The main difference between yield farming and staking is that yield farming typically involves providing liquidity to a pool to facilitate borrowing and lending, while staking involves locking up tokens in a wallet or delegating them to a stake pool to support a Proof of Stake (PoS) blockchain’s consensus mechanism.
Liquidity Pools
Liquidity pool providers, such as Uniswap, are groupings of tokens locked into smart contracts that facilitate token swaps and provide liquidity to DEXs and AMMs. When you provide liquidity to a pool, you typically receive liquidity pool tokens (LP tokens) representing your share of the pool. When you eventually withdraw your assets from a liquidity pool, the difference between the value of the withdrawn assets and the initial cost basis may be subject to capital gains or losses.
When providing liquidity to a pool, you receive LP tokens representing your share of the pool. The tax implications of liquidity pools arise when you withdraw your assets from the pool, as the difference between the value of the withdrawn assets and the initial cost basis may result in capital gains or losses.
Non-Fungible Tokens (NFTs)
Though not inherently DeFi projects, NFTs, or Non-Fungible Tokens, have made a substantial impact in the DeFi world, especially in representing membership or access rights within platforms and online communities. For instance, NFT-based membership tokens like Bored Ape Yacht Club (BAYC) not only provide users with unique digital art ownership but also grant them exclusive access to events, content, and governance rights.
Governance Tokens
Governance tokens, such as AAVE, are used to represent voting rights within a DeFi platform or protocol. Acquiring governance tokens can be a taxable event if received as a reward for participating in DeFi activity, such as liquidity pools or staking. The fair market value of the governance tokens at the time of receipt should be reported as taxable income.
As mentioned earlier, acquiring governance tokens may be a taxable event if received as a reward for participating in DeFi transactions. The fair market value of the governance tokens at the time of receipt should be reported as taxable income.
Decentralized Autonomous Organizations (DAOs)
Decentralized Autonomous Organizations (DAOs) are blockchain-based organizations governed by their members through voting mechanisms. Participation in a DAO can result in taxable income, similar to governance token rewards, and is considered by the IRS to be self-employment income for tax purposes. This classification may impact tax liabilities for DAO participants, as self-employment income is subject to self-employment tax in addition to regular income tax.
Overview of DeFi Taxes in 2024
Although IRS crypto tax guidance is continuously evolving, generally, DeFi participants should expect to pay ordinary income tax or owe capital gains tax on crypto all transactions.
| DeFi Income Tax Transactions | DeFi Capital Gains Tax Transactions |
| If you’re earning crypto through DeFi activities, it is generally seen as ordinary income, so you’ll pay income tax. DeFi income tax examples include:
| If you’re trading or using crypto for DeFi transactions, it is generally seen as a capital asset, so you’ll pay capital gains tax. Crypto capital gains tax examples include:
|
IRS Tax Code Guidance for DeFi in 2024
For the 2024 tax year, all DeFi participants should be aware of the following details of the U.S. tax code:
- Crypto Taxable Income: The IRS has clarified that the treatment of various DeFi-related incomes, including staking rewards, liquidity provider rewards, governance token rewards, and similar incomes are explicitly considered taxable income at the time of receipt.
- Mandatory Reporting of All Virtual Currency Transactions: The IRS requires taxpayers to report all virtual currency transactions, including those involving DeFi activities, regardless of the transaction amount or whether the transaction results in a gain or loss. This emphasizes the importance of maintaining comprehensive records of all your DeFi transactions to ensure accurate reporting on your tax return.
- Revised Tax Brackets and Rates: The IRS has updated the tax brackets and rates for 2024 to account for inflation. These changes may affect your overall tax liability, depending on your income and the specific DeFi activities you engage in. It is essential to stay informed about these updates and adjust your tax planning strategies accordingly.
- Increase in Standard Deduction: The standard deduction amounts have been increased for 2024, which may impact your overall tax liability, especially if you do not itemize deductions. Be sure to consider these changes when planning for your DeFi taxes.
- Form 1099-NEC and DeFi Income: The IRS requires that certain DeFi income, such as income earned from participating in a Decentralized Autonomous Organization (DAO), is considered self-employment income and should be reported on Form 1099-NEC. If you receive a Form 1099-NEC for your DeFi income, be sure to include this information on your tax return.
In addition to the guidance above the following two IRS forms are currently planned for implementation pending final IRS guidance:
- Changes to Section 6050I and Form 8300: According to the IRS, if you’re in a trade or business and receive more than $10,000 in cash in a single transaction or in related transactions, you must file Form 8300. The Infrastructure Investments and Jobs Act of 2021 amended Internal Revenue Code 6050I by holding certain digital asset transactions to the same reporting requirements as cash. The Treasury and IRS announced in January 2024 that businesses do not have to report certain transactions involving digital assets until regulations are issued.
- Form 1099-Digital Assets (1099-DA): Form 1099-DA, yet to be finalized, is a new IRS form designed for the reporting of transactions involving digital assets like cryptocurrencies and NFTs. This form is part of an effort to improve tax compliance and clarity around the taxation of digital asset transactions. If implemented, beginning in the 2025 tax year, the IRS will require digital asset brokers, centralized and decentralized, to send Form 1099-DA to investors who have engaged in certain crypto transactions including NFTs, staking, and mining.
Relevant IRS Tax Forms for DeFi Taxes
In addition to 1099 forms, here are two other IRS tax forms you should know about before diving into DeFi
- Form 1040 (Schedule 1): Form 1040 (Schedule 1) is used to report additional income, such as interest income from DeFi lending or staking rewards. You should include the total income from these sources on Line 8, “Other income,” and provide a brief description of the source of the income.
- Form 8949 and Schedule D: Form 8949 is used to report your capital gains and losses from the sale, exchange, or disposition of crypto assets, including DeFi transactions. You’ll need to provide details of each transaction, including the date of acquisition, date of sale, cost basis, and proceeds. After completing Form 8949, you’ll transfer the information to Schedule D to calculate your total capital gain or loss.
Minimizing Taxes on DeFi Transactions
In addition to understanding the tax implications of DeFi transactions, it is crucial to explore strategies to minimize your tax liabilities. Common approaches to consider include:
- Tax-loss Harvesting: Offset capital gains by selling or exchanging assets with losses. Maintain accurate records to identify tax-loss harvesting opportunities.
- Long-term Capital Gains: Hold assets for over a year for favorable long-term capital gains tax rates, especially if you’re in a higher tax bracket.
- Utilize Tax-advantaged Accounts: Consider using tax-advantaged accounts, such as IRAs or 401(k)s, for investing in certain crypto assets, as this may help defer or minimize taxes on gains and income.
DeFi Tax FAQs
Do you pay taxes on DeFi investments?
Yes, investors must pay taxes on gains from DeFi crypto transactions. Depending on how long an investor held the investment, DeFi transactions are subject to short-term or long-term capital gains taxes.
Is DeFi interest taxable?
Yes, interest earned from DeFi platforms is generally considered taxable by the IRS. This income is typically classified as interest income depending on the nature of your DeFi activities and your level of involvement. It’s important to report such earnings on your tax return to remain compliant with tax laws.
Is DeFi borrowing taxable?
The initial act of DeFi borrowing does not trigger a taxable event, but subsequent earnings from those borrowed funds could be taxable. Additionally, if a DeFi loan is taken out for personal reasons, interest expense is generally not tax-deductible, however, the interest expense on a DeFi loan taken out by a business may be tax deductible.
How are DeFi transactions tracked and reported by individuals to ensure accuracy in tax filings?
To ensure accuracy in tax filings for DeFi transactions, individuals can use specialized crypto tax software that interfaces with blockchain networks to track and report activities. For complex DeFi tax scenarios, a tax advisor who specializes in crypto investing can ensure transactions are reported properly on an investor’s tax return.
Are there tax implications for U.S. taxpayers engaging in DeFi activities on platforms based outside the United States?
International tax implications for U.S. taxpayers using overseas DeFi platforms include potential reporting under the Foreign Account Tax Compliance Act (FATCA) and the Report of Foreign Bank and Financial Accounts (FBAR), depending on the nature and location of the DeFi activities. If a DeFi protocol is considered a non-US “business entity” from a US tax code perspective, income from DeFi activities might be treated as ordinary income which is taxed at higher rates.
Can the IRS track DeFi wallets?
Although it can be challenging, DeFi crypto transactions are traceable on public blockchains. DeFi exchanges don’t report directly to the IRS, however, the IRS may receive crypto transaction data, when FATCA requires, from foreign firms reporting on assets held by U.S. taxpayers. Additionally, centralized crypto exchanges based in the U.S. like Coinbase report certain data to the IRS. Any profits from DeFi exchanges you transfer to a centralized institution may be reported to the IRS depending on the situation. Working with a DeFi tax advisor ensures that investors report all necessary transactions on their tax filings.
Is there DeFi tax on transferring between your accounts?
Transferring crypto between your own wallets used for DeFi is generally not a taxable event. These transfers are not considered a sale of the asset, with both the cost basis and holding period of the crypto asset remaining unchanged during the transfer process.
Harness Can Help With DeFi Taxes
DeFi offers exciting opportunities for participants in the decentralized financial ecosystem. However, it is essential to understand the tax implications of DeFi transactions and ensure compliance with the latest tax code changes, particularly as the industry continues to rapidly evolve.
At Harness, we can help you find tax advisors who understand the complexities of DeFi and are committed to helping you navigate the ever-evolving tax landscape. If you need assistance with DeFi taxes or want to learn more about our full range of services, register for Harness and start working with an experienced crypto-focused tax advisor today.
Tax services provided through Harness Tax LLC. Harness Tax LLC is affiliated with Harness Wealth Advisers LLC, collectively referred to as “Harness Wealth”. Harness Wealth Advisers LLC is an internet investment adviser registered with the Securities and Exchange Commission (“SEC”). Harness Wealth Advisers LLC solely acts as a paid promoter for unaffiliated registered investment advisers. Harness Wealth Advisers LLC’s registration as an investment adviser with the SEC does not imply a certain level of skill or training.
This document does not constitute advice or a recommendation or offer to sell or a solicitation to deal in any security or financial product. It is provided for information purposes only. To the extent that the reader has any questions regarding the applicability of any specific issue discussed above to their specific portfolio or situation, the reader is encouraged to consult with the professional advisor of their choosing.
