In this article of the Decentralised Finance (DeFi) series, we will introduce you to the tax relevance of token rewards.
DeFi has become one of the hottest applications of blockchain technology in 2020.
With DeFi, the character of a decentralized currency is extended from Bitcoin to the broader financial sector. The transfer of value through lending, borrowing, exchange trading, derivatives trading and also insurance is decentralized and without intermediation. Participants in the DeFi system receive the intermediation fee directly and theoretically it is possible for anyone to participate.
Receiving Rewards makes participation in the DeFi system particularly interesting.
Aave, Curve, Sushiswap and Uniswap for example grant you rewards for providing liquidity to a pool. Compound offers additional rewards for borrowing from a pool and Aave for voting on governance proposals.
Many DeFi protocols started centrally and with the goal of putting governance in the hands of community members over time. Community members can submit and vote on governance proposals. Proposals often include the distribution of rewards. As a result these can change rapidly.
Tax-wise a few questions arise from this: do you have to pay taxes on rewards? And if so, when and how much?
How do I calculate taxes on DeFi?
Many DeFi protocols give incentives to the users in form of airdrops and rewards. Airdrops are provided for free, no service is required in return and many users are not even aware of the worthless airdrops landing in their wallets. However, occasionally there are very valuable airdrops as it was the case with Uniswap, which resulted in users wondering about the tax implications. We explained how taxes on airdrops work in this article.
DeFi rewards on the other side require a service in return and are usually an additional incentive, e.g. for providing liquidity for a specific token pair.
In a decentralized protocol, users interact with a smart contract and keep their assets in their own possession. There is no need for a centralized custodian. DeFi Rewards can have features of incentivizing a service such as participation in the protocol (bounty), lockup in a decentralized network (staking), and interest-bearing investment (lending).
DeFi Rewards as an incentive for a service
Many protocols offer rewards for participation or certain interactions with the protocol. For example, Compound pays additional COMP rewards for Lending or even Borrowing. Rewards are also often available for participation in governance processes.
To properly consider such a reward in a tax return you can just mark the reward deposit transaction as “bounty” in the Blockpit Cryptotax software.
DeFi Rewards for providing liquidity to a liquidity pool (liquidity mining)
As a Liquidity Provider, you typically receive a share of the Liquidity Pool represented by an LP-Token. We consider this to be an exchange between the paid-in tokens and the paid-out LP-Token. This means that this process is to be recorded as a trade in the Blockpit application and already entails a realization of possible profits or losses when your assets are deposited in a pool. We covered the tax aspects of liquidity mining in this article: https://cryptotax.io/en-us/defi-taxes-borrowing-lending/
In many protocols, such as Uniswap, there are also incentivized pools where you get additional rewards of the protocol token in addition to the normal LP fees. The additional rewards or income derived from the incentivization can be classified as a “bounty” in the Blockpit Cryptotax application to receive proper tax treatment.
DeFi Rewards in Lending
In general, all income or rewards received by a taxpayer generated from the lending of cryptocurrencies must be reported to the IRS.
If you lend tokens in a decentralized protocol and receive interest for them it is obvious to consider the interest income as income from lending. However, in some protocols such as Comp and Aave, you receive an interest-bearing token when lending, such as cDAI or aUSDC. In this case, the interest is not paid out, but accumulated and retained until the interest-bearing tokens are exchanged back. In this case, the respective transactions of lending and redemption are considered as exchanges and taxed accordingly. The interest is reflected in the increased value of Compound and hence taxed as capital gains tax when the taxable event is triggered by exchange.
Generally, lending transactions, such es depositing, locking and withdrawing the lent amount are not considered a taxable activity. However, in some cases, cryptocurrencies can be exchanged to others in the course of interacting with smart contracts. In this case the exchange triggers a taxable event resulting in short-term or long-term capital gains.
You can find a detailed explanation of the taxation of lending in this article: https://cryptotax.io/en-us/defi-taxes-borrowing-lending/
In some protocols you receive additional rewards that are paid out in the form of governance tokens as an incentive for participating in the protocol. This incentive can be marked as “bounty” in the Blockpit Cryptotax application in order to receive proper tax treatment.
DeFi Rewards in Staking
In DeFi there is also the possibility of staking by locking up a token in a protocol. If rewards are paid out for the lock-up in the form of the tokens, you can consider these as staking income and mark them accordingly. Analogue to lending, coins that are exchanged for staking coins to be used in the protocol will trigger a taxable event.
Tax treatment of staking, lending and bounties in DeFi
Commercial or private
In the US the taxpayer must identify whether their trading is a hobby or a (self-employed) business for tax reporting purposes.
The main difference between trading as a hobby or as a business is that if any assets were received as reward trough the proof a stake consensus (“staking”), a lending transaction on a financial services platform (“lending”) or as bounties, in a business manner, the fair market value of the received assets on the day of receipt is qualified as self-employment income. In the private sector this is to be classified as other income.
The IRS uses the following criteria to determine whether a taxpayer’s profitable activity is deemed a hobby or a business. Please note one factor alone is decisive and all factors must be considered.
Whether you carry on the activity in a businesslike manner and maintain complete and accurate books and records.
Whether the time and effort you put into the activity indicate you intend to make it profitable.
Whether you depend on income from the activity for your livelihood.
Whether your losses are due to circumstances beyond your control (or are normal in the startup phase of your type of business).
Whether you change your methods of operation in an attempt to improve profitability.
Whether you or your advisors have the knowledge needed to carry on the activity as a successful business.
Whether you were successful in making a profit in similar activities in the past.
Whether the activity makes a profit in some years and how much profit it makes.
Whether you can expect to make a future profit from the appreciation of the assets used in the activity.
Staking, lending and DeFi Token rewards are considered other income for non-commercial activity and self-employed income if carried out as commercial activity.
The tax liability arises at the amount of the market rate at the time when the rewards are credited to you or claimed by you.
With DeFi, the crypto ecosystem has received an exciting addition whose revenues have tax implications.
As you can see, it can quickly become complex if you want to calculate the tax on your DeFi activities. That’s what our application is for. You don’t need to know anything about tax – our application calculates the acquisition costs and computes the taxable profit or loss, taking into account the relevant tax type, holding periods and exemption limits. At the end you get a detailed tax report, which is also accepted by tax advisors and tax offices.
As a leading provider in terms of optimized portfolio tracking including crypto tax calculation, we take care of the tracking and tax reporting for you, so you can focus on your DeFi activities.