The hot new strategy for crypto is something called Decentralized Finance (DeFi). It provides cash flow but it also provides a tax puzzle.
We’re going to look at some of the basic tax issues involved in DeFi in today’s article. This, and more, will be covered in Tax Tales From the Cryptocurrency, my new book that is due out late this summer.
DeFi Simply Explained
Decentralized Finance (DeFi) provides a platform for people to trade, borrow and lend crypto, easily and quickly. There is no middleman fees and delays.
Right now, the cryptocurrency Ethereum is the most popular platform for DeFi. However, there are a number of others that are quickly gaining popularity.
What We Know About Crypto Tax Now
Pretty much everything you do with crypto is taxable, except when you buy it. If you earn it, it’s taxable as ordinary income. If you sell it, it’s taxable as either short or long term capital gains. (If you lose money, it’s a capital loss) If you exchange it, it’s taxable. If you use it to buy goods or services, you pay tax. If you get an Airdrop, it’s taxable.
Pretty much everything is taxable when it comes to crypto. So, it’s no surprise that DeFi is also taxable.
DeFi Taxes on Lending Income
If you lend your crypto or contribute it to a platform that lends it, your earnings are taxable. That part is easy.
The part that’s not easy is determining whether the earnings are taxed like ordinary income or capital gains. That will depend on your DeFi platform.
If the DeFi platform works like a traditional lending outlet in which you are paid interest for lending your crypto, then you have ordinary income. Usually these payments are made in crypto.
On the other hand, if you are using a newer DeFi platform that has issued their own tokens, known as Liquidity Pool Tokens (LPT), you may be able instead to recognize the gain as a capital gain. The quantity in your crypto wallet stays the same. It’s just that the value of the LPTs increase. That’s the definition of capital gains. The asset goes up in value.
Some DeFi platforms are now giving incentive tokens in exchange for activity on their platform. This is known as yield farming. Those tokens (based on yield) are taxed as ordinary income.
There is a lot about crypto tax that we don’t know and yet the IRS is clamping down on non–filers. It’s a tricky time when it comes to taxes with your crypto. More than ever, you need to make sure that you and your tax advisors are up to speed on crypto tax.
Join us at the next Wednesday Coaching and bring your tax questions.