In the beginning, cryptocurrency was pretty basic. You could use it to make purchases and accept it as payment. If you wanted to make money, you needed to pay close attention to the crypto market, buying and selling at the right times based on the currency’s fluctuating value. In that regard, crypto worked in a very similar manner to stock — making money meant buying when the price was low and selling when it was high.

Since then, people have found new ways in which their crypto can work to generate even more income. To do so, they created decentralized finance (DeFi) platforms. A DeFi platform allows cryptocurrency holders to lend (and borrow) crypto without going through more traditional and cumbersome financial markets. It’s important to know, however, that DeFi markets involve transactions that the IRS taxes in a slightly different way.

Crypto Tax Basics

Let’s start with the crypto basics. As you may already know, the IRS generally counts cryptocurrency as an investment property rather than cash. Buying cryptocurrency is not a taxable event. You can buy it and hang onto it as long as you wish, tax-free. You only pay taxes when you realize a gain (or loss) just like you do when selling a stock or other property.

This means that you owe capital gains tax when you sell your crypto or use it to make a purchase. You’ll simply subtract what you paid for the currency from its current market value to determine your gain. You may also claim a loss if you sold your crypto for less than what you paid. Trading one type of crypto for another is also a taxable event if the currencies have different fair market values at the time of the exchange.

What is Decentralized Finance (DeFi) and How is it Taxed?

DeFi taxes work a little differently than basic crypto taxation. On the most basic level, decentralized exchanges allow you to lend (or borrow) cryptocurrency and make money from the interest as the loan is repaid. There are two basic ways to do so, and the tax rules for each vary from one to the other. If you wish to pay the more favorable capital gain rate on your crypto earnings as explained above, you need to look for a liquidity pool.

A liquidity pool works a little bit like mutual funds. You lend your crypto to a platform that puts your crypto and that of other lenders into a big pot. You then own a share of that pot based on how much crypto you lent.

As interest is paid on the loan, it accumulates in the pot or pool. You receive your share of the interest when you take your money back out of the pool. At that time you’ll recognize your capital gains and pay tax at the preferred capital gain tax rate.

You don’t have to use a pool to lend your crypto, however. Instead, you can lend it on a DeFi platform that keeps your loan separate from others. As the loan is repaid and interest income earned, your interest is deposited directly into your crypto wallet. Interest income received in this manner is considered ordinary income. It’s treated in the same way as the interest you get on your savings account at your local bank.

Ordinary Income vs. Capital Gains

DeFi markets let you cut out the middle man, but there is no dodging the tax man. When you’re making a tax plan or looking for tax guidance, it’s important to understand how your crypto is taxed. It’s impossible to decide whether to lend via a liquidity pool or not if you don’t understand the difference between a gain and ordinary income. So here’s the scoop:

Capital gain income comes from making investments, which is something the government wishes to encourage. To lure you into becoming an investor, the IRS cuts taxpayers a break by reducing the tax rate applied to money made via long-term investments. Depending on your income and filing status, the tax rate on long-term gains in 2021 is either 0, 15 or 20 percent. Remember that this is the tax rate for interest earned in liquidity pools.

If you choose to bypass the pool and collect your interest along the way, your interest income gets taxed at the same rate as your other income. In this case, your tax bracket will determine your tax rate, and you will pay that rate on the interest your crypto lending generates. As of 2021, the tax brackets are 10, 12, 22, 24, 32, 35 or 37 percent.

Yield Farming and Liquidity Mining Taxes

defi crypto taxes

So far we’ve covered the basics of lending crypto and liquidity pools, but some investors opt to take their crypto game to the next level. There are several ways to do this, including leveraging and borrowing strategies, but all involve some amount of risk. To keep things simple, we’re going to talk about two of the most basic strategies: yield farming and liquidity marketing.

Farming and liquidity marketing are two concepts often used in conjunction with one another to generate large amounts of crypto income. This is a little tricky and our explanation is admittedly a bit oversimplified for the sake of clarity. It will give you the general idea though, which is enough for now.

Liquidity mining is essentially a lure for cryptocurrency lenders. In this process, DeFi platforms offer investors a double incentive. If you lend your crypto to a certain exchange, they may offer to pay you interest and give you additional crypto tokens or coins. In doing so, they’re essentially paying you to lend your money to them.

Yield farmers do everything they can to maximize their returns. As such, they constantly watch for exchanges offering the highest interest rates and the best liquidity mining yields. When they find them, they take their crypto and the liquidity tokens they received and move them to a platform offering higher yields. They’ll watch the markets carefully and repeat this process as many times as necessary to maximize their return on their crypto investments.

In the offline financial world, the processes of liquidity mining and yield farming would look like this: Bob opens a savings account at his local bank. He does so because they agree to pay him an interest rate of 1 percent and give him $20 for opening the account. Three weeks later, another bank up the street advertises an interest rate of 3 percent on savings accounts. Bob would then close his account at the first bank and remove the money, including the $20 the bank gave him and any interest he’s earned so far. He would then deposit all that money in bank number 2. Bob would keep shifting his money around as needed to make sure he was always getting the best return on his money and receiving an extra $20 bonus whenever he could along the way.

In the real world, this process is time-consuming and requires a physical visit to both banks. In the crypto world, however, these transactions are simple and done with the click of a mouse. Cryptocurrency tokens move easily from one exchange to another, allowing investors to generate massive returns by constantly juggling their crypto.

All this crypto shuffling can generate good returns, but it can also complicate your taxes. The key to staying compliant with the IRS is to use some kind of tracking and tax software that can help to organize your many transactions. Many tax software programs are now compatible with the more popular crypto exchanges so you can easily import your transaction information to your tax return at the end of the year. This saves a lot of digging through paperwork and mental gymnastics at tax time, making it much easier to get your taxes correct.

Note that although making more crypto transactions does complicate things, the DeFi platform taxation rules we discussed earlier don’t change. As always, purchasing more crypto remains tax-free. Selling crypto or trading it can result in a capital gain as does earning interest through a liquidity pool. Interest directly deposited into your crypto account is taxable now as regular income as is any crypto acquired through liquidity mining. Trading one type of crypto for another may also generate a taxable event based on the fair market value of the currencies traded.

Tax Implications of Borrowing Crypto

So far we’ve talked about how DeFi markets affect your taxes when you lend them money, but you can also borrow crypto through a DeFi exchange. The tax consequences on this are a little fuzzy, however, mostly because the IRS has yet to define any specific rules for borrowing cryptocurrency through a DeFi exchange.

As a result, most CPAs are currently following the previously established guidelines for traditional types of borrowing. The act of borrowing itself won’t impact your taxes, but repaying the loan can. A business taking a crypto loan for business expenses can deduct the loan interest as usual. Interest paid on personal loans, however, is generally not tax-deductible. If you use borrowed crypto to invest in more crypto, interest paid on the original loan can count as an investment expense. As always, however, the IRS limits investment expenses, disallowing expenses that exceed your investment income.

These are the current tax rules for crypto borrowers, but they could change in the future. As crypto becomes more popular and mainstream, the IRS may feel the need to write special rules. This is something you’ll definitely want to watch for in the future.

Although we’ve tried to demystify some of the tax rules surrounding cryptocurrency and decentralized finance exchanges, the truth is that crypto is mind-blowingly complex. If you’ve been following the crypto game since its emergence, you may be very well-versed on this complicated topic. Many people are playing catch up, however, struggling to understand this new financial platform and the developments that it spawns — and there is no shame in being one of those people.

Get Professional Help With Defi Crypto Taxes

At Picnic Tax, we can match you with a CPA who specializes in cryptocurrency and can provide simple answers to your complicated questions. We stand ready to help you understand how this new investment vehicle will impact your taxes, whether you’re still in the planning stages or have already dipped your toe into the crypto waters. Either way, we look forward to working with you today!