DeFi has been one of the talked-about phenomena in the cryptocurrency space for over a year now. Often referred to as a kind of wild west, it represents the bleeding edge of fintech and perhaps the most compelling of blockchain use cases. When rare conversations about compliance occur, they’re generally in the context of whether or not DeFi should fall under the scope of laws governing securities.
But compliance in cryptocurrency is a multifaceted issue, and it’s not just protocol builders and exchange operators who need to be concerned about compliance. All the new ways to generate yield on cryptocurrency are also likely to initiate a corresponding compliance obligation in the form of tax reporting and possibly payments.
If you’ve used DeFi protocols in the last year, then the chances are that you’ve triggered a taxable event.
It’s worth noting that nothing in the IRS rules specifically recognizes DeFi protocols or transactions. The guidance given here is based on the current interpretation of IRS cryptocurrency rules as applied to DeFi protocols. Users outside the US should check with their accountant or tax office to find out more about their obligations.
Types of Tax on DeFi
In general, taxes on DeFi transactions fall into two categories depending on the platform:
- Ordinary income
- Capital gains income
Ordinary income is treated in the same way as your salary and taxed at your applicable marginal tax bracket. It doesn’t offer any savings opportunities, unlike capital gains income.
Capital gains income is subject to two levels of tax rate – long-term capital gains tax rates and short-term capital gains tax rates. The former is significantly lower and applies when you have held your assets for longer than twelve months.
An important point to note is that in the US, capital gains losses can offset any amount of capital gains income. However, they can only offset around $3,000 worth of ordinary income.
Now, we can apply these rules to how a DeFi user incurs gains on their deposits. When a user sends their crypto into a DeFi protocol, there are two ways they can earn from it. Either they’re issued with tokens representing their stake in a pool, and the token’s value changes with the value of the underlying asset, in the case of Compound or Uniswap.
When you redeem your cTokens or your LP tokens, they now represent the current market value of the underlying. In this case, the transaction is treated as capital gains because it’s structured as a trade.
However, when you earn tokens due to your investment, such as with Aave, where aTokens are minted in an equal quantity to the underlying, this is treated as ordinary income. At a point in time, you receive the tokens which have a market value. You declare that market value and pay income tax on it at your applicable marginal rate.
Similarly, when you receive governance tokens as part of a fair distribution mechanism, you must declare these tokens as income.
Getting Ahead of the Curve
“For many new cryptocurrency users who have not yet filed taxes after trading cryptocurrency, they are not aware as to how difficult it can be to reconcile their trading activity. Seasoned users are aware of the difficulties and try to keep them up to date.”
However, he revealed his belief that there is a large majority of users who are aware of their obligations but have found it too difficult to comply and have delayed submitting their tax return as they try to sort everything out. In this case, people are incurring serious risks of being audited by their tax authorities, which could result in a tax “red flag” being painted on their backs.
“The earlier you can get ahead of the state of your portfolio and transactions, the better, while it’s still fresh in your memory,”
Brunette’s advise for crypto users is to catch up sooner rather than later.