Hodling and trading are by no means the only ways to generate income in Crypto anymore.
Especially DeFi (decentralized finance) paved the way for passive means to generate income without selling your precious coins or ferociously trading every up, down or side ways trend.
So what’s the idea behind passive income? It is the old analogy of the apples from your tree. You generate income by selling the fruit your apple tree (investment) bears while continuing to own the tree. Passive because the idea is that you don’t invest a lot of your time in the venture and instead are free to enjoy your spare time doing what you enjoy doing.
The simplest and very popular form of passive income is lending. As an investor, you can lend your crypto assets to borrowers via centralized and decentralized platforms for a chance to earn interest. The returns are usually fixed and paid out at pre-set intervals.
U.S. tax payers need to identify whether they are a hobby or business lender for tax purposes. Subsequent sales of the lending rewards are subject to short term or long term capital gains tax in the U.S.
In Germany lending investors are taxed at the personal income tax rate.
Tax payers in Austria can benefit from the special tax rate of 27,5% on lending rewards and subsequent sales are tax free outside the one year holding period.
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.
In all cases, if you need to exchange a coin to receive a lending coin, this triggers a taxable event.
Passive income can also be derived by staking. This belongs to the concept of the proof of stake mechanism. Participants ensure the validity of the blockckain 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.
To stake or not to stake will hopefully not become an existential question for german tax payers but is nevertheless a timely and relevant one. In its draft paper from July 2021 the BMF (equivalent to the U.S. Department of Treasury) considers a narrow interpretation of the law to extend the holding period of staked coins to 10 years. For more information please refer to our commentary on the draft.
Yield farming is a decentralized (DeFi) way to generate passive income. Liquidity providers in a DeFi protocol contribute to smart contracts that take on the role of market makers in traditional centralized systems. As the name indicates, liquidity pools provide the liquidity in a decentralized system and replace traditional order books. In return for providing liquidity to the pool, investors receive liquidity providing tokens (LP-Tokens), that represent the share in the liquidity pool and entitle the holder to a proportional amount of trading fees from the pool.
Yield Farming or Liquidity Mining is an evolved concept of maximizing returns by leveraging the power of smart contracts. It basically seeks to combine various components of DeFi across different DeFi protocols to get maximum return. DeFi governance tokens incentivize users to use platforms by rewarding them with governance tokens.
Swapping coins to the protocol for liquidity providing tokens triggers a taxable event with all the known tax consequences. The same applies when funds are withdrawn. Fee income from liquidity pools and governance token rewards at taxed at the personal income tax rate in Germany and Austria at the time they are claimed or attributed to the tax payer.
U.S. tax payers have to declare liquidity fee income and the receipt of governance token rewards as a hobby or as a business.
Borrowing from the liquidity pool and depositing collateral does not trigger a taxable event.
Cloud mining is used as an alternative to earn passive income for investors in countries where electricity costs prevent economic solo mining. In cloud mining a third party takes up the technical aspect of crypto mining on your behalf. In essence, you pay a platform to rent or buy mining machines from their mining facilities.
U.S. tax payers have to declare mining activity as a hobby or as a business.
In Germany and Austria the pre-requisites for mining as a business are typically not given in the case of cloud mining. Consequently any cloud mining returns are taxed at the personal tax rate and subsequent sales are tax free after a one year holding period.
This is a non-comprehensive discussion of passive income generating methods from a tax perspective and no financial advise. Please be diligent and DYOR. Let us take care of your crypto taxes to free up even more of your precious time.