We all know taxes are a necessary evil. But what about when they're just downright confusing? That's why we are here to demystify the DeFi tax process and make it easy for you to understand. We'll help you navigate your way through tax season, so you can rest easy knowing that everything is taken care of. Let's get started!
What is DeFi?
Although 'DeFi Taxes' may be unpopular, the concept of 'DeFi' is not alien to most people in the Cryptocurrency community. DeFi, or decentralized finance, is a growing movement that is turning the traditional financial system on its head. With DeFi, there is no need for third-party intermediaries like banks or brokers.
Instead, transactions are made directly between two parties using Ethereum-based smart contracts. This not only reduces fees and speeds up transactions, but it also gives users more control over their finances. In addition, DeFi applications are usually open-source and built on top of existing protocols, which makes them highly accessible and easy to use. As more people become aware of DeFi and its potential, we expect the ecosystem to grow at an explosive rate.
There are certain benefits to choosing DeFi over the traditional banking system:
- Lower Fees: One of the biggest advantages of using DeFi over traditional banks is that you will save a lot of money in fees. With traditional banks, you often have to pay fees for account maintenance, wire transfers, and even ATM usage. With DeFi protocols, you don't have to pay any of these fees. This can save you a lot of money in the long run.
- Greater Accessibility: Another advantage of using DeFi over traditional banks is that it is much more accessible. With traditional banks, you often need to go through a long and complicated process to open an account. With DeFi protocols, you can often create an account in just a few minutes. This makes it much easier and faster to start using DeFi protocols.
- More Privacy: Another advantage of using DeFi over traditional banks is that you will have more privacy. Traditional banks share your financial information with many different people and institutions. With DeFi protocols, your financial information is only shared with the people or institutions you want to share it with. This means that your financial information is much more secure with DeFi protocols.
- Greater Security: Another advantage of using DeFi over traditional banks is that you will have greater security. Traditional banks store your money in centralized databases vulnerable to hacks and attacks. With DeFi protocols, your money is stored on the blockchain, which is much more secure. Your money is much less likely to be stolen or lost if you use DeFi protocols.
- Higher Interest Rates: Finally, one of the biggest advantages of using DeFi over traditional banks is that you will earn higher interest rates on your deposits. With traditional banks, the interest rates on your deposits are often very low. With DeFi protocols, the interest rates on your deposits are often much higher. This can help you earn more money on your investments over time.
What are DeFi Taxes?
Now that you know how DeFi works, it shouldn't be surprising that any monetary gains from using DeFi will be subject to taxation. Years ago, the Internal Revenue Service (IRS) published a guideline that authorizes Cryptocurrencies to be treated as properties and not currencies (for tax purposes), which means that Cryptocurrency exchanges, sales, and purchases are all taxable events that you must disclose on your tax returns.
How DeFi Taxes work?
You should be aware of the tax implications of your DeFi investments, as tax authorities worldwide are coming down on cryptocurrency investors. DeFi is constantly evolving, even though we have yet to explore half of the options and capabilities, DeFi offers to investors.
Cryptocurrencies usually fall under one of two tax categories: capital gains tax or income tax, and every tax office has special rules on how to tax them. Whether your cryptocurrency investment is regarded as regular income or as the sale of an asset determines how this is interpreted. Estimating your DeFi Tax position using income or capital gain
From a tax viewpoint, your cryptocurrency investment, whether DeFi or not, will always be seen in one of two ways:
- As a source of revenue, examples of cryptocurrency payments include salary payments, mining, and stake payments. It would, after that, be liable for income tax.
- The sale of a capital asset, such as a stock or a rental property.
A few ways to dispose of crypto include:
- Selling for fiat money.
- Exchanging for another cryptocurrency.
- To buy goods or services or, in some nations,
- As a gift.
It would, after that, be liable for capital gains tax.
Even though DeFi is still a relatively new technology, the individual transactions that makeup DeFi investments already have apparent taxing positions. Let's determine whether some DeFi transaction comes across as a form of income or capital gain by looking at it and then applying the appropriate tax method. We'll describe some events of transactions possible in DeFi and how they would be taxed.
DeFi Tax on Crypto Borrowing
You are neither making money nor selling anything when you borrow cryptocurrency. Therefore, neither capital gains tax nor income tax would apply to this. This, in short, means that this event is not taxable.
DeFi Tax on Crypto Loaning
Even though you are not disposing of the asset, using DeFi platforms to lend cryptocurrency may be viewed as a type of disposal for tax purposes and subject to capital gains tax.
This is because many DeFi protocols swap your borrowed cryptocurrency for a new crypto token when you lend it. Most nations consider crypto-to-crypto trades to be disposals, and as such, they are subject to capital gains tax.
Of course, this wouldn't be the case if you didn't get a token in exchange for your asset. Moving your cryptocurrency to a particular vault or pool constitutes disposal rather than transfer in situations like this. This is comparable to a tax-free transfer.
DeFi Tax on Liquidity Mining
The particular protocol you're utilizing and how it pays you will determine the tax you have to remit on liquidity mining.
For your asset, some protocols provide you with one token as compensation. Keeping your assets long in the pool doesn't necessarily generate more tokens. Instead, the more active the pool, the more valuable your token becomes. More importantly, you can only realize gains or profits upon selling the token at a later date. If your liquidity mining is anything like this, it will probably be considered a capital gain and be taxed accordingly.
On the other hand, some DeFi protocols will provide you with numerous tokens in exchange for supplying liquidity. To put it another way, you're getting new cryptocurrency in return for a service you're offering. It is more likely that this would be considered income and subject to income tax because you are "earning" fresh tokens.
The tax you pay will depend on which of the two ways your protocol operates, as almost all DeFi protocols work in one of these. In summary:
- Taxes on income apply if you use liquidity mining to "earn" additional coins or tokens.
- Capital gains tax may apply if your token balance remains unchanged, but its value rises.
Adding Liquidity
You're not selling your asset when you add money to liquidity pools. Instead, you are transferring money to a different location, similar to a transfer that is not regarded as a taxable event. It is not liable to income or capital gains tax because there has been no disposal, and you are not receiving any additional income.
However, receiving a token in exchange for your increased liquidity could be interpreted as exchanging one cryptocurrency for another. It might be subject to capital gains tax as a result.
Removal of Liquidity
You are not receiving any new funds or selling any of your cryptos when you withdraw your initial investment from a liquidity pool. This indicates that neither income nor capital gains tax would apply.
As said earlier, exchanging one cryptocurrency for another could occur if you acquired a token in return for your money and are exchanging it back for your asset. Once more, this might expose it to capital gains tax.
DeFi Tax on Staking
Fortunately, the DeFi tax on staking is reasonably straightforward because many tax authorities have previously published guidelines on staking, which we can use to stake on DeFi protocols. Most tax authorities worldwide treat staking winnings as an additional income source, and so charge income tax on them.
DeFi Tax on Play-to-Earn
There has yet to be a definitive guideline regarding play-to-earn DeFi or gamified DeFi tax. You will still have to pay taxes on it, though.
You will have to pay income tax if it is established that you are earning money, such as when you gain new tokens from play-to-earn games. The token's fair market value will determine your payment on the day you receive it. Like the play-to-watch approach, earning tokens from it may be considered income and liable to income tax.
Any profit made through the sale, exchange, use, or gift of these earned tokens will be subject to capital gains tax.
DeFi Tax on Derivatives and Margin Trading
Since you aren't disposing of an asset, trading itself is tax-free. You will, however, have a realized profit or loss when you close on your trade. The level of trading determines how this is taxed in various nations.
These earnings will be taxed as income for people who are perceived to be trading on a business scale. However, only your realized gains or losses will be subject to capital gains tax if you are perceived to be trading as an individual investor.
DeFi Tax on Swapping
You can "swap" tokens on decentralized exchanges like Uniswap, a process identical to buying and selling cryptocurrencies on controlled exchanges like Coinbase. Therefore, the same principles apply: you pay capital gains on the proceeds, and the losses are deducted from your overall tax liability as capital losses.
DeFi tax on interest payment
Since interest payments in cryptocurrencies are subject to capital gains tax, they qualify as investment expenses and are thus tax deductible. Of course, this presumes that you borrowed in a typical manner without experiencing any additional issues that would alter the situation.
Also Read: How to invest in web3? to make shit ton of money.
Conclusion
There are a few instances/events - based on the form of DeFi transactions - that determine whether or not you will be taxed, or when you're taxed - how the tax will come.
If you gain crypto from an asset that appreciates, you must pay taxes on capital gains. A few activities require paying tax, including buying goods and services with crypto, selling crypto for fiat, and trading one token for a different one. While all these would be taxed as capital gains, earning crypto directly is taxed as ordinary income. Examples of how you can make money from crypto include: staking your earnings, airdrops and hard forks, earned wages on crypto, and earnings from mining.
In the case of loans, you are not taxed when you use crypto as collateral for loans, but that is on the condition that you do not receive a different token in return, and your collateral is neither sold nor exchanged.
DeFi taxes' complexity has made many investors shy away from learning the concept. It is even completely alien to some in the crypto community, hence the need for universal regulations guiding the idea. We have, however, been able to run through how all the activities you perform using DeFi are taxed, and it's safe to say you've just read through the best guide to DeFi taxes.
