Key points to remember
- Capital gains tax and income tax apply to DeFi income depending on the activities and platforms involved.
- Liquidity pool tokens are generally subject to capital gains, while native tokens are more commonly subject to ordinary income tax.
- You can take out a crypto loan to pay taxes without triggering another tax event by selling crypto – just watch out for margin calls.
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Taxes are one of the most opaque problems in crypto, with many investors still unsure of how to calculate taxes on profits or if they owe taxes. The DeFi space, in particular, has many mobile elements in terms of taxation and asset classes.
Crypto Briefing has put together a brief guide that explains how users’ DeFi income could be taxed, as well as ways they can save money during tax season.
DeFi taxes ordinary income over capital gains
Users will have to pay either a capital gains tax or ordinary income tax on profits from lending crypto on DeFi platforms. Check out the DeFi platform documentation to see if capital gains or income tax applies.
Platforms that pay crypto directly to users’ wallet balance generate ordinary income for their users. If users lend BTC and receive BTC in return, users will likely be taxed as they would on their salary or others. ordinary income, and marginal tax rates apply. The tax applies to the market value of the crypto at the time a user receives it.
However, when a platform pays into its own liquidity pool token (LPT), the profits from selling that LPT usually fall below. capital gains tax. Capital gains tax applies to all property, including crypto, which is also classified as property. This can be cheaper in some cases, especially when the asset is held for more than a year and lower capital appreciation rates apply.
If a user earns crypto as ordinary income and sells that crypto after it has increased in value, they may need to pay both income tax and capital gains tax.
When users provide liquidity to a DeFi pool with crypto assets and withdraw those assets in exchange for their LPT reward, users realize capital gains upon withdrawal.
Examples of LPTs from two major DeFi lending platforms, Compound and Aave, may provide more clarity.
Aave issues its interest-bearing aTokens at a 1: 1 ratio with the underlying asset provided by users. So, if users provide 100 DAI, they will receive 100 aDAI. If users provide 10 ETH, they will receive 10 aETH. Aave’s aTokens are taxed as ordinary income – when the aToken balance increases, they are subject to income tax on that balance.
Taxable events here include:
- Users pay a capital gains tax on ETH when they originally exchange it for aETH.
- If users earn more aETH, they are subject to ordinary income tax on that income.
- When users sell or burn aETH, they again recognize capital gains or losses depending on whether the price of the underlying asset, ETH, has changed.
To note: Capital losses do not offset ordinary income tax, so if users sell ETH for a capital loss, it is not deductible from the ordinary income tax bill.
The compound, on the other hand, does not emit cTokens in a 1: 1 ratio. When a market generates interest, cTokens are worth an increasing amount of the underlying asset – their cToken balance does not increase, but rather the value of these cTokens increases. This is taxable as capital gains tax rather than ordinary income.
COMP, on the other hand, the native compound token, is issued as part of its governance incentives and other incentives. When a DeFi platform distributes its native token as a reward, it is generally taxed as ordinary income. This applies to COMP, BAL, YFI and other native DeFi tokens.
How to save money with DeFi taxes
DeFi users can take out crypto loans to save money on taxes.
When they borrow crypto as collateral, they do not generate a taxable event. Many DeFi users take out loans such as providing ETH collateral to borrow funds to pay taxes without triggering more taxable events.
It is important to note that if the value of the collateral (in the above case, ETH) goes too low, then a margin call or liquidation will be triggered. IRS will treat this as if a user has sold the funds, generating another capital gain or loss event.
How to declare DeFi taxes
It is recommended to consult a specialist in professional crypto-taxation when it comes to declaring DeFi taxes. CryptoTrader.Tax, TaxBit, and Token fee are three examples of tax firms experienced in the taxation of cryptocurrencies, using crypto-tax software to calculate final user returns.
It is always a good idea to maintain good record keeping throughout DeFi and crypto trading and to invest in making the tax season as seamless as possible, giving users more time to focus on them. opportunities that arise.
Disclosure: At the time of writing, the author owned Bitcoin.
Disclosure: When you use some of the above links related to tax services mentioned in this article, you are supporting independent journalism on Crypto Briefing. It does not affect our reports. We continue to pursue fair and balanced editorial. For more information on our partnership with Sorare, do not hesitate to contact us on Twitter or Telegram.
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