Complete Guide to DeFi Taxes (2024 Update)

May 20, 2024

DeFi, or decentralized finance, introduces a new world of investment opportunities and financial freedom. However, it also brings unique challenges when it comes to tax reporting. The IRS has released very little guidance about cryptocurrency taxes, leaving tax professionals to apply decades-old regulations to this brand-new technology.

Our experienced crypto tax professionals created this comprehensive guide to taxes on DeFi as a way to explain and clear up legal ground that, in many cases, is uncharted. At Gordon Law, we’ve been at the forefront of crypto tax law since 2014, helping investors maximize their returns while staying compliant with IRS rules.

In this article, we’ll break down the fundamentals of how DeFi activities are taxed, covering everything from capital gains to ordinary income, and identifying non-taxable events. Whether you’re yield farming, margin trading, or receiving airdrops, it’s crucial to understand how each transaction impacts your tax bill.

After reading, you’ll be in a better position to keep more of what you’ve earned. Ready to make sense of DeFi taxes? Let’s dive in.

Key takeaways

  • DeFi transactions can trigger capital gains tax or ordinary income tax. Long-term capital gains are generally taxed at lower rates than short-term capital gains or ordinary income.
  • Many common DeFi activities—including borrowing, providing liquidity, bridging, and wrapping—can be taxed in various ways depending on the specific circumstances.
  • DeFi tax accounting is some of the most complicated accounting on earth. Professional help is highly recommended to avoid IRS penalties.

How is DeFi taxed? Understanding the basics

The money you earn from DeFi falls into 2 categories: capital gains or ordinary income. Before we dive into the specifics of how DeFi is taxed, make sure you understand this essential information:

  • When you sell or dispose of an asset for a profit, that’s subject to capital gains tax.
  • When you earn crypto some other way, that’s subject to ordinary income tax.
  • A taxable event is a transaction that may trigger either type of tax.
  • Capital gains are considered short-term if you held the asset for less than 1 year, or long-term if you held the asset for 1 year or more. Long-term capital gains have the most favorable tax rates (see the tables below).
  • Every buy, sell, swap, deposit, and transfer of digital assets needs to be listed on your tax return. The more activity you have, the more complicated your tax accounting becomes.

In this article, we’ll walk through several examples of DeFi activities and their tax implications.

DeFi tax rates for short-term capital gains and ordinary income (Tax year 2023)

Tax Rate Single Filer Married Filing Jointly Married Filing Separately Head of Household
10% $0 to $11,000 $0 to $22,000 $0 to $11,000 $0 to $15,700
12% $11,000 to $44,725 $22,000 to $89,450 $11,000 to $44,725 $15,700 to $59,850
22% $44,725 to $95,375 $89,450 to $190,750 $44,725 to $95,375 $59,850 to $95,350
24% $95,375 to $182,100 $190,750 to $364,200 $95,375 to $182,100 $95,350 to $182,100
32% $182,100 to $231,250 $364,200 to $462,500 $182,100 to $231,250 $182,100 to $231,250
35% $231,250 to $578,125 $462,500 to $693,750 $231,250 to $346,875 $231,250 to $578,100
37% $578,126 or more $693,751 or more $346,876 or more $578,101 or more

DeFi tax rates for long-term capital gains (Tax year 2023)

Tax Rate Single Filer Married Filing Jointly Married Filing Separately Head of Household
0% $0 to $44,625 $0 to $89,250 $0 to $44,625 $0 to $59,750
15% $44,626 to $492,300 $89,251 to $553,850 $44,626 to $276,900 $59,751 to $523,050
20%  $492,301 or more $553,851 or more $276,901 or more $523,051 or more

 

Interacting with DeFi: Taxes on common activities

Participating in the DeFi ecosystem usually involves multi-step transactions and several transfers between different wallets. In the world of DeFi, these activities might be considered basic, but from a tax and accounting perspective, they’re extremely complicated.

Remember: When it comes to reporting crypto taxes, every transaction must be listed on your tax return. That includes buys, sells, swaps, deposits, and transfers.

Every time you convert assets or even move them between accounts, tax reporting becomes more challenging. Because of this, it’s practically impossible to report DeFi taxes correctly unless you’re a tax professional with deep knowledge and experience of cryptocurrency.

With that in mind, here’s an overview of several common DeFi tax scenarios.

Transferring crypto between wallets

It’s extremely common for crypto investors to transfer digital assets between different wallets. This is especially true in DeFi, where investors typically interact with several different blockchains.

Even though self-transfers are extremely common, they can create a serious tax headache.

Tax implications of transferring assets in DeFi:

Transferring crypto between different wallets that you own is not a taxable event. However, when it’s time to calculate your cost basis, self-transfers can create a lot of problems.

Let’s look at an example:

  • You buy 1 ETH for $2,000 and sell it for $5,000, creating a capital gain of $3,000.
  • However, you bought that ETH on Coinbase and sold it on OpenSea. OpenSea doesn’t have any record of the original $2,000 cost basis—only a “deposit” of 1 ETH on the date of the transfer. Let’s say ETH was worth $4,500 at the time.
  • Without proper accounting, self-transfers look like ordinary income, which is unfavorable to investors.
  • In this scenario, it might look like you have $4,500 worth of ordinary income in addition to the $3,000 capital gain.

Crypto tax software was designed to fix this problem—but it doesn’t work perfectly. Thanks to the volume and complexity of DeFi activity, you may see a lot of transfers labeled as taxable deposits in your software-generated crypto tax report.

Bridging assets

Bridging refers to moving crypto assets between different blockchain networks. Often, specific digital assets are not compatible with different chains, so bridging can involve changing the asset in various ways to interact with a different chain.

Bridging crypto may or may not be taxable, depending on the circumstances and who you ask.

Tax implications of bridging in DeFi:

  • Most tax professionals believe that simply moving assets from one chain to another is not taxable—it’s just a transfer.
  • However, most bridges provide a swapping function. For example, to use your ETH on the AVAX chain, you might swap your ETH for AVAX. This is a taxable event, as if you sold the ETH for cash.

Gas fees in DeFi

DeFi investors can rack up a lot of blockchain maintenance fees (known as gas fees) due to the high volume of trades, swaps, and transfers that are typically involved in this type of investing.

Taxes on gas fees:

In some cases, gas fees can offset your tax bill.

  • Gas fees incurred during a sale, swap, or other taxable event can be added to your cost basis. A higher cost basis means lower capital gains.
  • Gas fees incurred during self-transfers cannot be added to your cost basis.

Wrapping crypto tokens

In some cases of bridging, you may need to “wrap” your coins rather than swap them. For instance, you might wrap your BTC so you can use it on the Ethereum network, creating wBTC.

Tax implications of wrapping in DeFi:

When it comes to wrapping, you can choose a more conservative stance—resulting in higher taxes and lower risk of IRS problems—or a more aggressive one.

  • Conservative stance: Treat each wrapping event as a taxable swap.
  • Aggressive stance: Treat each wrapping event as a non-taxable transaction.

Not sure which tax treatment to choose? Consult a professional to discuss your specific situation.

Governance tokens or utility tokens

Governance tokens, otherwise known as utility tokens, are cryptocurrency tokens that give users control and voting power over a particular blockchain.

Taxes on governance tokens:

Governance tokens are typically taxed as ordinary income at the time of receipt. However, “spending” the tokens to vote on projects is not considered a taxable event, creating a unique tax issue.

  • Conservative stance: Treat the “spend” as a non-taxable transfer and write off your cost basis as a loss.
  • Aggressive stance: Increase the cost basis of remaining governance tokens.

This is a complex area of tax law, so it’s wise to consult a professional about your options.

DeFi airdrops

Investors can receive an airdrop of additional cryptocurrency tokens as a reward for interacting with certain platforms, especially newer projects. New DeFi platforms often offer airdrops to reward engaged users and grow their audience.

Some investors use a strategy called airdrop farming to try to maximize their airdrop payouts. This may involve using multiple wallets to interact with a single blockchain.

Similarly, some DeFi platforms offer points as a reward for interacting with the chain. The more points you have, the higher your chances of receiving a crypto airdrop. Investors can engage in points farming to try to maximize their airdrop payouts.

Taxes on DeFi airdrops:

  • Airdrops are taxable, and they’re considered ordinary income. The amount of income is based on the tokens’ fair market value at the time of receipt.
  • The more wallets you use, the more difficult your DeFi tax reporting becomes. Airdrop farmers and points farmers should keep this in mind.
  • With points farming, the points themselves are not taxable; only the resulting airdrops are taxable.
  • Beware of scam airdrops and “sh*tcoins.” These are not taxable, but if you’re using crypto tax software, they may be falsely counted as taxable airdrops.

Taxes on collateralized DeFi loans

Decentralized finance allows for peer-to-peer crypto loans that are managed automatically by smart contracts. The borrower must provide collateral in order to take out the loan. For example, you might provide AAVE in order to borrow USDT.

In the world of DeFi, it’s simple to borrow crypto or lend crypto and earn interest—but it’s not so simple to report this activity on your taxes.

Keep in mind, there is no precedent in the tax law for situations where you loan property (i.e., digital assets) and receive property in return. Tax professionals rely on their interpretation of the U.S. Tax Code to determine how to treat crypto-for-crypto loans.

Taxes for DeFi lenders

Interest earned from crypto lending is taxable as ordinary income. However, there’s an important snag when it comes to reporting.

How much interest is earned in DeFi? Let’s look at an example:

  • Sarah loans out 1,000 ETH tokens on a 90-day loan. She earns an additional 2 ETH as interest.
  • At the beginning of the loan term, 1 ETH is worth $2,000. Sarah loaned 1,000 ETH, or $2,000,000.
  • At the end of the loan term, 1 ETH is worth $5,000. Sarah receives 1,002 ETH, or $5,010,000.
  • How much interest did Sarah earn? Did she earn 2 ETH (valued at $10,000 total), or did she earn $3,010,000? This is the reporting challenge.

We recommend hiring a tax professional to discuss the tax implications in your specific situation.

Taxes for DeFi borrowers

Taxes for borrowers are even more complicated. There are many details, nuances, and complex scenarios that we won’t get into in this guide, but here are the main points you need to know:

  • DeFi loans can be more favorable from a tax perspective than simply swapping one type of crypto for another. If you trade AAVE for USDT, you incur a capital gain. But if you provide AAVE as collateral for a USDT loan, this does not trigger a capital gain.
  • A loan is not considered taxable income.
  • Repayments toward the loan are always taxable events that trigger capital gains. Finding the cost basis can be a challenge.
  • The issue of how much interest is incurred, as detailed above, applies to borrowers as well as lenders.
  • Borrowing stablecoins is generally much simpler to account for than borrowing other types of crypto.
  • Interest payments may be tax deductible if they’re conducted as part of a trade or business.

Since DeFi lending presents so many accounting challenges and legal gray areas, we highly recommend seeking professional tax guidance for this area, whether you’re borrowing or lending.

Automatic liquidation

Automatic liquidation is a way for DeFi protocols to avoid overextending their resources. For tax purposes, it’s considered a taxable sale that can incur a capital gain.

Let’s look at an example:

  • Jarrod deposits $1,000 worth of UNI so he can borrow $500 worth of SOL. The loan period is 90 days.
  • During the loan period, UNI dips in price and Jarrod’s deposit becomes worth less than $500. The protocol liquidates (sells) his UNI to cover the debt.
  • The sale is a capital gains tax event. Jarrod may have a capital gain or capital loss, depending on how much he initially paid for those UNI tokens.

Liquidity pool tax and staking taxes

Liquidity pools are an essential part of the DeFi ecosystem; they provide the liquidity needed for DeFi loans, margin trading, and more.

Investors can provide liquidity by depositing, or staking, crypto in the pool. Then, they’re rewarded with a share of the platform’s trading fees—similar to earning interest on a loan. This is often referred to as staking or liquidity mining. But how does liquidity pool tax work?

Tax implications of DeFi staking:

Liquidity pool rewards and the entrances/exits to these pools can be taxed as either ordinary income or capital gains. Let’s look at an example:

  • John provides 10 ETH and 100,000 PEPE to the Uniswap liquidity pool. He receives a Uni V3 NFT as a representation of his stake in the pool.
  • When John exits the liquidity pool, he returns the Uni V3 NFT and receives 15 ETH and 150,000 PEPE. The additional tokens represent the interest he’s earned.
  • Tax treatment option 1 – Capital gains: Swapping ETH and PEPE for the Uni V3 token, and vice versa, could be considered capital gain tax events.
  • Tax treatment option 2 – Ordinary income: John could treat the ETH/PEPE and Uni V3 swap as a non-taxable event. The additional 5 ETH and 50,000 PEPE that he earned could be taxed as ordinary income.

Neither option is necessarily conservative or aggressive. Either one could result in a higher tax bill, depending on your income bracket and the specific circumstances of your case. Generally, capital gains tax rates are more favorable than ordinary income tax rates.

Single-sided liquidity

On the Uniswap V3 platform, DeFi investors can provide liquidity with only one asset of the liquidity pair. This is known as single-sided liquidity or single-sided staking.

Tax implications of single-sided staking:

The tax implications for single-sided staking are the same as those for standard DeFi staking. Rewards can be taxed as either capital gains or ordinary income.

Yield farming

Yield farming adds another layer of complexity. With yield farming, investors can stake their liquidity pool tokens (such as Uni V3) and earn additional rewards.

Tax implications of yield farming:

The tax implications of yield farming are the same as those for standard DeFi staking. Yield could be taxed as capital gains or ordinary income, depending on the mechanics of the platform you use.

Proof-of-stake rewards

To make matters more confusing, the term “staking” in cryptocurrency investing can refer to 2 separate activities.

In one scenario, you can stake to provide liquidity, as detailed above. In the other scenario, staking is similar to cryptocurrency mining: It’s used to validate transactions on the blockchain.

You lock up some of your crypto on a particular blockchain (such as Ethereum or Solana) for a set amount of time, with the hope of being selected to validate groups of transactions called “nodes.” You earn proof-of-stake rewards in the form of additional tokens, but these rewards may be locked until the contract is complete.

Proof-of-stake tax implications:

Proof-of-stake rewards are typically taxed as ordinary income, but not until you have “dominion and control” over them (in other words, when they become unlocked). Learn more about this type of staking here.

Liquid staking

Liquid staking, or restaking, is a way to earn proof-of-stake rewards, but remain liquid by receiving a tradeable asset in exchange for the staked asset. For example, if you stake 5 ETH on the Lido platform, you’ll receive 5 STETH in exchange. The original ETH remains locked for a set amount of time, earning rewards, but you can use the STETH right away.

Tax implications of liquid staking:

  • Most tax professionals believe that the conversion of ETH to STETH, and vice versa, is a capital gains tax event.
  • The proof-of-stake rewards are taxed as ordinary income, based on the fair market value when you have dominion and control over them.

Leverage trading

In addition to earning interest, many DeFi investors use leverage trading to magnify their trades. For example, you may only be able to afford $10,000 worth of crypto, but you can control a portfolio 10x that size. With leverage trading, both gains and losses are magnified.

Margin trading and derivatives trading (including futures and options) are popular types of leverage trading. We’ll explain each of these types of trading and their tax implications below.

Keep in mind: Even “basic” DeFi transactions typically require professional tax help because of their complexity. If you engage in leverage trading, the need for an experienced crypto tax professional increases tenfold. There are many legal gray areas that require an analysis of your specific situation.

Margin trading

Margin trading is the practice of borrowing funds from a broker and using those funds to trade more crypto than you would be able to afford on your own. In the DeFi world, the broker is the exchange or protocol you use. The borrower must repay the initial loan, plus interest.

Tax implications of margin trading:

  • The loan is not considered taxable income, since you have an obligation to repay it.
  • Each time you use digital assets to make a payment toward the loan, the transaction is considered a capital gains taxable event.
  • Capital gains tax applies to any trades, swaps, or conversions performed using the borrowed assets.
  • If you’re using margin trading in a business, or if you’ve elected Trader Tax Status, interest payments may be tax deductible. Reach out to our crypto tax team to learn more.

Futures trading

Futures contracts are used in both traditional and DeFi markets. A crypto futures contract is a type of derivative contract where a buyer and seller agree on the sale of a digital asset at a specific price on a specific date in the future.

Both the buyer and seller are obligated to go through with the transaction when the time comes; in the world of crypto, this occurs automatically through smart contracts.

Unlike in traditional markets, DeFi also has perpetual futures with no expiration date.

Taxes on crypto futures trading:

  • Purchasing a futures contract with cryptocurrency is a taxable event (as if you sold the crypto for cash).
  • In theory, capital gains from futures trading can have more favorable tax rates than typical cryptocurrency gains. For regulated futures, 60% of capital gains are taxed as long-term gains and the remaining 40% are taxed as short-term gains.
  • Long-term gains are taxed at lower rates than short-term gains.
  • The 60/40 rule only applies to futures contracts that are regulated by the SEC or CFTC. Most digital assets are not regulated and do not apply for this tax treatment.
  • It’s highly recommended to consult a tax professional to discuss taxation of your crypto futures trading.

Options trading

Crypto options contracts are another type of derivative contract. With options, the contract holder has the option to buy a digital asset at a specific price (the strike price) up to a specific date (the expiry date). But unlike with futures, the contract holder is not obligated to do so.

Taxes on crypto options trading:

  • Purchasing an options contract with cryptocurrency is a taxable event (as if you sold the crypto for cash).
  • If you exercise the option to buy the designated crypto at the strike price, this is a capital gains tax event. If you held the contract for 1 year or less, the gain is considered short-term. If you held the contract for more than 1 year, the gain is considered long-term.
  • If you don’t exercise the option and the contract expires, you’ll lose your initial investment. You may be able to write this off as a capital loss.
  • If you sell the contract or trade it for another asset, that’s considered a taxable event.

Do DeFi exchanges report to the IRS?

DeFi exchanges don’t currently report information to the IRS, but that doesn’t mean you can get away with leaving DeFi off your tax return. Here are some important points to keep in mind:

  • Soon, DeFi exchanges that are considered “brokers” will have to report crypto transactions on Form 1099-DA. Uniswap is a prime example of a DeFi exchange that will likely be considered a broker.
  • When you intentionally leave certain income sources off your tax return, the IRS may consider this tax evasion or tax fraud. Both crimes can lead to serious consequences, including a prison sentence.
  • During a crypto tax audit, the IRS will trace your full transaction history. They can easily find out about decentralized accounts that you didn’t report. Withholding this information during an IRS audit can lead to a referral to the Criminal Investigation Division.

Learn more in this video:

How to calculate DeFi taxes

When it comes to calculating your DeFi taxes, there are very few scenarios where you don’t need a professional accountant. That’s not a sales pitch, it’s the honest truth—and it’ll save you money in the long run. Here’s why:

To report DeFi trading on your tax return, you need to account for every buy, sell, trade, transfer, and deposit.

For capital gains tax events, you need to find the following information for every transaction:

  • Cost basis: How much you initially spent on the specific batch of digital assets.
  • Proceeds: How much you sold the assets for.
  • Acquisition date: When you initially bought or acquired the specific batch of digital assets.
  • Sale or disposition date: When you sold or otherwise disposed of the assets.

It sounds simple enough, but think about how it works in the real world. If you have a transaction where you sold SOL at $75, but you’ve purchased SOL at a wide range of price points, how do you know whether you incurred a gain or a loss? That’s the simplest scenario out of all the examples we’ve walked through in this guide.

There are many cost basis calculators on the market to help answer that question, but here’s an insider tip: None of them offer a complete DIY solution for your average trader. How could they when so many transactions require professional interpretation of the tax law? That’s where professional cryptocurrency accounting comes in.

That’s not to say software isn’t helpful—it’s an essential tool for our team of highly experienced crypto accountants and tax attorneys. And some software certainly handles DeFi better than others.

But there’s no getting around it: DeFi accounting is perhaps the most complicated type of accounting out there. Most tax professionals don’t even know how to do it, so why risk doing it yourself? Trust the original crypto tax pros at Gordon Law.

Why choose Gordon Law for DeFi tax reporting?

✅ No more guesswork! Our seasoned accountants help you find every opportunity to save on taxes, while ensuring you comply with regulations to avoid penalties.

✅ Save hours of time compared to DIY solutions.

✅ Our team is passionate about blockchain technology, which is why we’ve been at the forefront of crypto tax law since 2014.

✅ We’ve helped more than 1,000 crypto investors and prepared more than 1,500 crypto tax reports.

Don’t risk overpaying your taxes or facing penalties due to misreporting. Contact Gordon Law today and discover how easy DeFi taxes can be!


Sources:

  1. IRS Notice 2014-21
  2. Revenue Ruling 2019-24
  3. Frequently Asked Questions on Virtual Currency Transactions
  4. Chief Counsel Advice (CCA) 202124008

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