The Tax Implications of DeFi: A General Overview

DeFi, or decentralized finance, has experienced unprecedented growth over the last few years, resulting in a market cap of approximately $85 billion as of October 2021. Built on blockchain technology and cryptocurrency, DeFi has the potential to revolutionize finance by allowing users to borrow, lend, trade, and execute other financial transactions without a centralized authority or financial intermediary. Despite its popularity, the IRS has yet to issue specific guidance on how DeFi transactions should be viewed from a tax perspective. Fortunately, Notice 2014-21, which the IRS originally issued in 2014 and updated this year, can shed some light on how certain transactions conducted on DeFi platforms should be taxed.

In this posting, we will briefly explain what DeFi is and the tax implications of common DeFi transactions, including staking, lending, and yield farming/liquidity mining. It is important to note, however, that the taxation of DeFi transactions is an evolving area and future IRS guidance could supersede or clarify the principles laid out by the Service in Notice 2014-21.

What is DeFi?

Currently, most financial transactions are managed by centralized authorities and financial middlemen. Consider, for example, a simple wiring of funds to an account located at another financial institution. To initiate the wire, the sender will likely be required to pay a fee and provide certain information on the recipient. The sender’s bank will then send a message with payment instructions to the recipient’s financial institution, which will deposit its own reserve funds to the recipient’s account while the wire is pending. The two banks will settle payment after the funds have been deposited. Although the wire transfer can generally take 2 to 3 days to complete, the backend process can be time-consuming, inefficient, and exclusionary to people who do not have access to financial institutions or the means to pay the associated fees.

By contrast, DeFi are peer-to-peer networks that empower users to conduct financial transactions without a centralized authority or financial intermediary. Instead, smart contracts that power decentralized applications, also known as dApps, automatically execute agreements between parties when specified conditions are met. Thus, in the wire transfer above, a dApp would facilitate the transfer of funds upon the satisfaction of predetermined conditions, allowing the parties to bypass the banks altogether.

Existing IRS Guidance on Cryptocurrencies

In Notice 2014-21, the IRS clarified that cryptocurrencies are treated as property for federal tax purposes. Thus, a taxpayer will recognize capital gain or loss on the sale of cryptocurrency equal to the difference between the cost she acquired the coin (including fees and other transaction costs) and its fair market value at the time of sale. As with other property, gain on the sale will be taxed at long-term capital gain rates (a federal maximum rate of 20%) if the cryptocurrency was held for more than a year and subject to short-term capital gain rates (a federal maximum rate of 37%) if the asset was held for a year or less.

In the notice, the IRS also described other instances where a taxpayer would recognize income from a cryptocurrency transaction. For example, if a taxpayer provides services in exchange for cryptocurrency, she will recognize ordinary income from the receipt of the currency. Perhaps more importantly, the Service has made clear that an exchange of cryptocurrency for other property, including other cryptocurrency, is a taxable transaction.

Although the IRS did not specifically touch upon DeFi in Notice 2014-21, the general principles laid out by the Service in the notice (as described above) are instructive in determining the tax consequences of common DeFi transactions such as staking, borrowing, and yield farming/liquidity mining. We discuss the taxation of each of these transactions further below.

1. DeFi Staking

DeFi staking involves locking crypto assets into a smart contract in exchange for becoming a “validator” on a Proof-of-Stake (PoS) blockchain network. Specifically, in the absence of a financial intermediary to manage and audit a transaction, PoS systems rely on validators to verify the accuracy of transactions within a specific block. Validators are rewarded with tokens from the platform for each block deemed valid and accepted by the blockchain network. Conversely, a validator can lose its staked crypto assets if it does not properly validate a block. The prospect of losing the staked crypto assets and winning rewards encourages validators to enforce the rules on the platform, which in turn, ensures the integrity of the DeFi network.

Under the principles laid out by the IRS in the notice, a validator would be treated as performing services – that is, validating the accuracy of transactions within a block – in exchange for the reward of tokens of that platform. Thus, the validator would recognize any reward of tokens as ordinary income (and taxed accordingly at ordinary rates). What is less clear, however, is how the loss of staked crypto assets should be treated from a tax perspective. Should the validator be able to recognize an ordinary loss on the forfeiture of such assets? Or would such losses de disallowed? There is an argument to be made that the losses should be disallowed, given that the loss of staked crypto assets are presumably a result of a validator’s bad behavior or failure to follow network rules.

2. Lending/Borrowing on a DeFi Platform

Perhaps the most practical application of DeFi has been the lending and borrowing of funds via a smart contract running on the network. In a typical DeFi lending transaction, a lender deposits fiat currency into a DeFi lending platform while the borrower pledges its cryptocurrency as collateral for the loan. The lender receives interest during the term of the loan. Upon the repayment of the loan in full, the collateral securing the loan is returned back to the borrower.

The IRS notice does not cover the taxation of DeFi lending transactions, but general tax principles governing traditional lending transactions should apply here. From the lender’s perspective, the interest earned on the loan should be taxed as ordinary income. From the borrower’s perspective, the deductibility of the interest it pays depends on the use of the loan proceeds. If the borrower uses the loan in the ordinary course of business, the interest should be deductible. On the other hand, interest on personal loans would not be deductible. Likewise, if the borrower uses the loan proceeds to invest in other cryptocurrencies (or other taxable investments), the amount of interest that can deducted is limited to the investment income earned during the taxable year, with any excess interest deductions carried forward to later years.

3. Yield Farming/Liquidity Mining

As DeFi networks have grown in popularity, yield farming, also known as liquidity mining, has emerged as a new way to maximize returns by putting crypto assets to work. Essentially, a decentralized exchange, like any centralized exchange, requires liquidity to facilitate trades, lending, and other financial activities in the marketplace. To achieve this, users’ crypto assets are combined into liquidity pools to provide liquidity to the marketplace. The users that fund these liquidity pools are known as liquidity providers (LPs). In exchange for their crypto assets, LPs receive pool tokens representing their share of the tokens in the liquidity pool, as well as interest (for the use of their crypto assets) and reward tokens.

By way of example, assume that Eric contributes 1 ETH into a Uniswap liquidity pool, which he acquired five years ago at a price of $500 and which has a fair market value of $2000 at the time of contribution. In exchange for the ETH coin, Eric receives 20 UNI tokens representing his share of the tokens in the liquidity pool. Given the Service’s position on the exchange of cryptocurrencies, Eric’s contribution of 1 ETH coin in exchange for 20 UNI tokens would likely be considered a taxable event. Thus, Eric would recognize a long-term capital gain of $1,500 ($2000 FMV – $500 cost basis) at the time of contribution. The UNI tokens would have a cost basis of $100 per token or $2000 in total. There is an argument, however, that the transaction can be viewed as a contribution of 1 ETH as collateral for the 20 UNI tokens, which would be a nontaxable transaction. In light of Notice 2014-21, however, the more conservative position would be to treat the exchange of 1 ETH for 20 UNI tokens as a taxable event.

As part of his participation in the liquidity pools, Eric also receives interest and reward tokens in proportion to his share in the pool. As described above, both the interest and the tokens he receives for the use of his crypto assets is treated as ordinary income subject to tax at ordinary rates. Nine months later, Eric decides to liquidate his position in the pool when the price of an Ether coin declines to $1,000. When Eric exchanges the 20 UNI tokens for the 1 ETH coin, he would recognize a short-term capital loss of $1,000 ($2,000 – $1,000).

Conclusion

Although the IRS has yet to issue specific guidance on the tax implications of DeFi, the Service’s positions on cryptocurrency in Notice 2014-21 can inform our understanding of how common DeFi transactions should be taxed. Nevertheless, we anticipate that more comprehensive (and potentially stricter) guidance from the IRS should be forthcoming in light of DeFi’s growing sophistication and increasing scrutiny from Congress and the federal government.

 

For more, see our Cryptocurrency and Blockchain Page.

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