Working out how to pay your DeFi taxes is a tricky subject to approach. Here’s a quick guide.
American yield farmers, busy chasing the 1000+% APYs that fueled this summer’s $9 billion decentralized finance craze, rarely discuss something as dry as taxes. Yet, given the Internal Revenue Service’s crackdown on crypto tax payers, it’s clear the taxman still cometh for those making fortunes from DeFi.
Yield farming used to refer to those who spent the year collecting interest from decentralized, non-custodial lending protocols such as Compound, Maker and Aave, or fees for participating in liquidity pools of decentralized exchanges, such as Uniswap. In around June, the deal got even sweeter when Compound in June introduced $COMP, a governance token earned by using the protocol. All the other protocols followed suit and the tokens skyrocketed in value.
The DeFi market blew up so fast that the IRS hasn’t issued any specific guidance. But the IRS has taken a keen interest in cryptocurrency; a question about crypto trading heads the front page of its new tax return, and the IRS is chasing after US taxpayers for failing to report taxes correctly.
In the absence of up-to-date IRS guidance on yield farming, a market that only began in earnest in June, the burden is now on yield farmers to work out how much they owe in taxes. Anticipating this, several crypto accountancy software companies have spent the past few months tweaking their code to help yield farmers prepare their transaction data for the scrutiny of their accountants. Decrypt, like a helpful house-elf, sought their advice on how to file your DeFi taxes.
Track how much money you’re making (or losing)
When filing your DeFi taxes, it’s first necessary to work out exactly how much money you’ve made. This is easier said than done. Each cryptocurrency transaction triggers a “taxable event,” and people use crypto several times each day to pay for coffee, rent taxis and to… who are we kidding—day trade. Then there’s income, like that gained through earning governance tokens or interest from crypto loans or from cryptocurrency mining. All must be accounted for.
The IRS just released the 2020 Draft Form 1040. Every single American is going to be asked right there: “At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”
— CoinTracker (@CoinTracker) August 21, 2020
There are several companies devoted to building tax software that scrapes on-chain transaction data in preparation for accountants, among them TokenTax, Lukka, Recap, and CoinTracker. Crypto accountancy software extracts all of this on-chain data and puts it into a single spreadsheet. This software integrates with exchanges and popular cryptocurrency protocols to make sure that you don’t miss anything. Many also support the newer DeFi protocols.
“It’s quite hard to figure out, actually what you did, because it’s all just within the Ethereum blockchain. And you’ll need a service to help you figure that out,” Alex Miles, cofounder of TokenTax, told Decrypt.
Work out how much you owe in taxes
But scraping the data is only half the battle. Then you need to work out what you must pay the IRS.
There are two types of taxes relevant to all of this: First are capital gains taxes. Each crypto transaction triggers a “taxable event,” which means you have to pay capital gains tax on it—if you bought Bitcoin at $1 a decade ago, and sold it in September at $12,000, you’d have to pay capital gains taxes on your $11,999 profit. The second is income tax: if you have, say, earned fees from investing into the liquidity pools of decentralized exchange Uniswap, then that constitutes income and must be reported as such.
Things get a little more complicated with some of the newer decentralized finance mechanisms, most notably how to deal with governance tokens earned from participating in lending protocols or liquidity pools.
“The IRS is treating all the cryptocurrencies as one bucket—they’re not separating the DeFi tokens from other cryptocurrencies like Bitcoin…so it’s quite challenging for tax practitioners to figure out like how this generic property treatment should be applied to each transaction, because everything is new,” Shehan Chandrasekera, CPA, CoinTracker’s head of tax and strategy, told Decrypt.
But even though the IRS has not issued any DeFi-specific tax guidance, “there’s enough tax guidance in the crypto space in place for us to infer the tax implications for these DeFi-specific transactions,” said Chandrasekera.
A couple warnings:
Those creating the tax software say that yield farming could be taxed in different ways—in tax, “there’s no right or wrong answer,” said Chandrasekera. “There’s different positions you can take because there’s no direct guidance,” he said.
And how to proceed “totally depends on how the protocol works, said Miles. “Each protocol requires specific attention because what’s happening in each smart contract is slightly different. So you need to understand, in a really clear way: What is actually going on, what’s happening with the funds, and how does that affect the holdings on someone’s address? And that’s not easy.”
Down the rabbit hole
Though each DeFi protocol is unique in its own complicated way, many are variations on a theme. Here’s a basic primer:
Decentralized lending protocols are the cornerstone of this summer’s bountiful harvest. DeFi lending uses non-custodial protocols as intermediaries. These intermediaries handle the loans and reward you with interest.
Generally, the mechanics of lending protocols work like this: you put some money in a lending protocol and receive a voucher that represents your loan. This voucher will increase in value over time, and can exchange for cryptocurrency once you cash out.
Take yearn.finance, also known as yEarn, a yield aggregator that moves your money around the different lending protocols. It gives depositors yTokens.
“There’s a few ways to look at it,” said Miles about the tax implications of yearn.finance’s yield farming. “One way: because that share of that token is slowly increasing in value, you could think of it as a trade.” Trades are liable for capital gains tax, which must be calculated each time you sell your cryptocurrency.
To this argument, Chandrasekera adds a supporting premise: yearn.finance will return the equivalent of the cryptocurrency, plus interest—not the exact cryptocurrency you staked in the smart contract. Under US tax law, cryptocurrency is not fungible in the same way that, say, each US dollar is treated as indistinguishable from the last. Since each cryptocurrency is treated as unique, “That other token could be considered new property,” he said, thus triggering a taxable event.
Another way, notes Chandrasekera, is to take an “aggressive” stance. With this, you could argue that this does not constitute a taxable event since this is simply staking money as collateral, and not a sale of property.
2. Interest and governance tokens
Once you lend or deposit funds in liquidity pools—pools of money that make a decentralized exchange, such as Uniswap, run smoothly, you may start receiving a reward. Here, Roger Brown, a crypto tax specialist at Lukka and a former IRS employee, advises that you treat the reward as income, but also think about whether it triggers a capital gain or loss. (Miles said that income tax is levied on some lending protocols, including Aave—more details are here).
Brown told Decrypt that “yield is certainly ordinary income, taxable at ordinary rates.” It’s “not a capital gain because you haven’t sold it or exchanged something,” he said. But when do you start adding interest to your tax bill? “You have to pay taxes at the time that interest hits your wallet,” said Chandrasekera—not when you cash out.
If you think $UNI will drop in price due to farming sell pressure, wait to claim the tokens!
You will need to file income taxes on the claim event.
— TokenTax (@TokenTax) September 17, 2020
And how about the practice of earning additional governance tokens from these protocols at no additional effort? Chandraseka said that governance tokens count as a form of interest, too, and thus constitute ordinary income. You would only pay a capital gains tax if you flogged it on a secondary market.
SushiSwap, for instance, is a billion-dollar clone of decentralized exchange Uniswap that lets users earn additional $SUSHI tokens when they fund its liquidity pools. “The act of you claiming that token would be considered income. And that’s very clear, because that’s the value that you receive for providing services (in this case liquidity),” said Miles.
Ways to reduce your tax bill: Ethereum fees
The major DeFi protocols are all housed on the Ethereum blockchain. The Ethereum blockchain, now fairly dated, is very expensive to use and transaction fees, also known as gas fees, are very high. In the tax world, it’s possible to offset income with expenditures, so you can use Ethereum fees to reduce your tax bill. “It’s going to be a mini tax return on your tax return,” said Zac McClure, TokenTax’s other co-founder. “If people aren’t tracking that, they’re going to be overpaying their taxes.”
But it’s not so simple…
Those principles are helpful as a rough guideline. But “there hasn’t been any guidance on this yet,” said Miles. With new DeFi protocols popping up all the time, it’s like playing whack-a-mole.
Miles said that filing taxes for yearn.finance’s yield farming is completely different to filing them for DeFi lending protocol Aave. Aave comes with its own set of rules, since Aave’s smart contract is unique in the way users claim interest, he said. “If you were to send someone an Aave token, that would then trigger the claim. And that’s very different from the way that Compound’s cTtokens and yearn.finance’s yTokens work,” said Miles.
Brown told Decrypt of an additional problem created by DeFi lending protocols. With centralized crypto loans companies, like Californica-registered Cred, you need to consider whether foreign persons have tax liabilities in the United States. The issue is more complex in DeFi protocols, as you may not know where the borrowing activity occurred and who is paying you a return. That’s relevant to whether the U.S. can tax a foreign person, and there’s no specific IRS guidance on it yet, he said.
What to do next?
Brown said that there are few easy answers for these complex issues. “Whatever you should do, you should be consistent. And you shouldn’t be cherry-picking a position based on whether there’s a gain or loss,” he said. He added that “you should try to treat similar transactions similarly, from a principle perspective and legal perspective.”
It’s best practice to rely on crypto tax software, said Chandrasekera. “And if things get even more complicated, you should definitely talk to an accountant who’s familiar with cryptocurrency taxes,” such as…Chandrasekera.
Cover for your mistakes
Still, this stuff is complicated. Errors may be made, and there are tips to compensate for mistakes.
McClure advises to track earnings in US dollar terms. Imagine you earn $1,000 in Decrypt’s forthcoming token as part of some squalid DeFi yield farm. Should Decrypt’s token collapse as the quality of our articles continues to deteriorate, in a year someone buys your holdings for just $1 dollar. “Now you have a $999 loss, but you still earned that income in 2020. So you still owe taxes,” said McClure. If you haven’t set any money aside to account for this loss, you’d be screwed, particularly if you live in a state with a high income tax rate.
Miles said that “good financial etiquette would be to sell a third of what you make set aside in dollars, so that you have enough money [to pay for] taxes.” Either in a regular savings account, or to convert a portion of those holdings to stablecoins, and put them into another yield farming account “to keep your money at work but still save for taxes.” Some crypto lending firms, like Cred, are insured. “Just be careful where your assets are held,” said McClure.
File your taxes
So…how do you actually file your taxes? You’ll need the following tax forms, said Chandrasekera. First off, everyone must tell the IRS whether they’ve traded crypto. That question appears on the front page of the mandatory tax form, Form 1040.
In here you’ll find Schedule B for tax on interest, and Schedule 1 for income. For capital gains tax, you’ll have to request Form 8949 and fill in Schedule D. These forms can be downloaded from the IRS and are also built into most tax software, like TurboTax.
No, really, file your taxes.
There’s also the issue of enforceability, said Chandrasekera. The IRS, concerned that US taxpayers were underreporting their cryptocurrency transactions, worked with centralized exchanges, among them Coinbase, and sought the services of blockchain analytics firm Chainalysis, to trace funds of those it suspected of evading taxes.
Then it sent out thousands of letters demanding that they pay up. But with DeFi, said Chandrasekera, that’s impossible. “You can have tax rules, but who’s going to enforce them? DeFi is… decentralized,” he said. “You cannot send letters to truly decentralized platforms. That’s the challenge.”
In the absence of additional guidance about DeFi, Chandrasekera advises that people still file their taxes. “There’s enough guidance for us to be conservative and just report something; reporting something is better than nothing,” he said.
Reporting the transaction starts the “statute of limitation,” a piece of legislation that legally limits the IRS’s ability to audit you for the next three years after filing the return. “If you don’t report any of [your] DeFi transactions, you never start the statute of limitation. And that means that the IRS can audit you, like, forever.”