What is Decentralized Finance (DeFi) and how is it taxed?
Decentralized Finance is a quickly growing field of cryptocurrency that allows people to access financial services like trading, borrowing, and lending, without delays or extra prices incurred by a middleman like with traditional financial institutions. DeFi also utilizes automated market making (AMM) and liquidity pools to provide decentralized trading.
DeFi lending income taxes
If you lend your crypto or contribute it to a platform that supplies loans of crypto, you will be liable for taxation on whatever you earn from lending your crypto. This lending income is treated as ordinary income (like income on salary), or as capital gains (gains from trading) depends on your DeFi platform.
Traditionally, lending platforms pay earnings from interest directly to your crypto balances, i.e., for lending ETH, you’d earn ETH and see your wallet balance increase accordingly. If you earn crypto tokens for lending (i.e., your balance increases when you earn interest income), then you recognize this as ordinary income (like income earned as payment / salary).
DeFi platforms, however, have issued their own tokens, also known as Liquidity Pool Tokens (LPTs), where you may recognize this income as capital gains. This is because adding/removing liquidity is structured like a trade or token swap. In these cases, such as with cTokens, the value of your LPTs increases — but the quantity shown in your ETH wallet remains the same.
When you convert your cTokens back to the original asset, the cost basis of your cTokens is compared to the amount of the original asset you receive in return to calculate your gain from interest accrued by the pool.
Certain DeFi transactions, like depositing to a platform that mints a token for your assets (e.g., ETH -> aETH on Aave), may or may not be a taxable event. This question also applies to entering and exiting liquidity pools.
Examples of such transactions include:
If you deposit LINK into Aave, you receive a LINK in return.
If you deposit USDC into Compound, you receive USDC in return.
If you add to Uniswap’s DAI/ETH liquidity pool, you send DAI and ETH and receive
UNI-V2 tokens representing your share of the pool in return.