Author: Steven McGrath
The explosive growth of decentralized finance (DeFi) has created a new investment opportunity ecosystem that is only limited by developers' programming capabilities and economic creativity.
While the UK Customs and Revenue recently issued guidance on the treatment of DeFi transactions, the US Internal Revenue Service has not yet issued any authoritative guidance on the matter. Understanding the tax treatment of DeFi in the US may be challenging. In this article, we will carefully examine some DeFi transactions and discuss how US tax principles may apply. Due to the multiple uses of certain terms in DeFi, we will provide detailed definitions for clarity.
Overview of DeFi Taxation in the US
Similar to the UK, US income tax rules are based on the economic characteristics of the transaction activity rather than structural features. Profits from investments are generally subject to income tax in two ways:
- Ordinary tax rates;
- Capital gains from the sale of assets, which are only considered taxable income when the asset is sold.
Cryptocurrencies are considered property in the US, but unlike specific types of property such as securities or commodities, the US has not yet established any specific tax regulations or rules for cryptocurrencies, such as the Wash Sale Rule or the securities lending tax-exempt provision under US Code 1058, which are currently implemented for securities or other traditional financial products.
If a part of a DeFi transaction involves exchanging cryptocurrency or other digital assets for goods or services, the IRS will consider it ordinary income and subject it to taxation. On the other hand, if the asset appreciates in value, the gains realized upon future sale or disposition will be considered capital gains and taxed accordingly.
Cryptocurrency Swaps
Swapping refers to the activity of exchanging one cryptocurrency for another through autonomous DeFi protocols. From a tax perspective, this is no different from cryptocurrency trading on centralized exchanges. Cryptocurrency swaps are simply a form of asset disposal, resulting in capital gains or losses, and the value of the acquired assets will determine the gains from selling the cryptocurrency and the cost basis of the received cryptocurrency.
Yield Farming
Yield farming, sometimes referred to as liquidity farming, is a common term in the DeFi space. It involves various activities and projects, but generally entails earning returns by providing cryptocurrency (liquidity) to a liquidity pool and receiving fees and tokens as compensation based on the proportion of the cryptocurrency's liquidity in the pool.
The concept of yield farming involves two basic activities—lending and staking. While these terms are used in the DeFi space, they do not always accurately reflect the economic principles of DeFi transactions.
Cryptocurrency Staking
Cryptocurrency staking involves temporarily depositing and locking cryptocurrency in a designated wallet to activate detection software and become a validator on a Proof of Stake (PoS) blockchain. In short, it involves staking cryptocurrency to gain voting rights. Validators receive new blocks from the blockchain network's peer-to-peer nodes and can vote on whether to support the block (known as validation) to ensure the security of all transactions. Redeeming the stake will yield corresponding cryptocurrency rewards.
Staking pools are another form of staking, where cryptocurrency is deposited into a liquidity pool, but this term is more applicable to describing transaction validation on PoS blockchain networks.
Is Providing Cryptocurrency to a Liquidity Pool Considered Lending?
In the US tax principles, providing cryptocurrency to a liquidity pool should not be considered traditional lending and may be treated as a taxable disposition.
US tax principles focus on the economic activities occurring during transactions rather than their labels. In the context of liquidity pools in DeFi, some professionals may compare it to lending, but it is still different from typical property lending. Cryptocurrencies are considered property, not currency, so the tax treatment of lending cryptocurrency differs from lending cash. Lending cash is not considered a taxable event because cash is not property. Even lending property, such as a car or a house, is not taxed because strictly speaking, "lending" a car or a house only allows someone else to use the property for a period, and the borrower compensates the lender in return. While in their possession, they cannot sell or alter it; they can only use it.
It is evident that providing cryptocurrency to a liquidity pool is not the same as described above. When cryptocurrency is provided to a liquidity pool, the user providing liquidity is not just using the cryptocurrency in the pool, but acquiring it and can engage in decentralized token-to-token transactions with other users in the pool. This action implies that the investor has relinquished control of the cryptocurrency and only agrees to redeem an equivalent unit or value at a future date. According to US tax principles, relinquishing ownership of property, even with an agreement to reclaim the property at a future date, still requires the property to be taxed. In short, providing cryptocurrency to a liquidity pool means relinquishing ownership of the units, and similar to relinquishing ownership of property, it is generally considered a taxable event and will determine whether the units have generated capital gains or losses based on the asset's cost basis.
When investors exit the pool, they will receive new units, and the liquidity value of the new units will be recorded as the cost basis. If the liquidity value of the new units changes compared to the initial value, the investment in the liquidity pool may involve capital gains and losses.
Why Aren't Liquidity Pools Tax-Exempt Like Stock Lending?
When stocks are lent for securities lending, the lender is considered to have completely relinquished ownership of the stock, and the borrower generally gains ownership and can dispose of it at will, including selling the stock. However, according to US Code 1058, securities lending or transfers are tax-exempt, and the resulting gains and losses from the transferred securities are also exempt from taxation, but this tax exemption does not apply to cryptocurrencies. Although liquidity pool transactions are similar to stock lending methods, cryptocurrencies are not tax-exempt in this scenario.
This example illustrates that certain tax exemptions for traditional financial products (such as securities) do not apply to cryptocurrencies. Conversely, some rules do not apply to cryptocurrencies, such as the Wash Sale Rule, which only applies to securities, stocks, and other assets, while cryptocurrency traders can still benefit from investment strategies known as "wash sales."
Taxation Rules for Earnings in Liquidity Pools
When holding liquidity in a liquidity pool, earnings are typically obtained from the pool. Many people consider these earnings as interest, but according to US tax law, although they are conceptually similar, they should not be considered interest. The distinction between the two is crucial; in tax law, receiving or paying interest enjoys special treatment, so mischaracterizing earnings as interest may lead to incorrect tax reporting. According to tax law and case law, interest is compensation paid using cash, not property. In the crypto ecosystem, earnings represent compensation using cryptocurrency, not cash.
Earnings are generally considered ordinary income. When the return is based on a contractual right, it is considered income. In other words, because liquidity pools operate through smart contracts, similar to physical contracts, these contracts specify the earnings that users providing liquidity to the pool will receive. As ordinary income, the fair market value of the earnings should be reported as income when received. The reported amount will also be set as the cost basis of the cryptocurrency received as earnings. In the future, this cost basis will be used to determine whether capital gains or losses have been realized when disposing of the asset.
Can Earnings Be Converted into Capital Gains?
Recently, developers have begun creating DeFi products aimed at converting earnings into capital gains. This is achieved by converting the generally unit-based earnings into the value growth of the investor's cryptocurrency (liquidity) in the pool through a protocol.
The protocol will log the time when cryptocurrency is deposited into the liquidity pool, and its earnings are reflected not by an increase in cryptocurrency units, but by the time growth of the statutory value of the original units. Therefore, when investors exit the pool, the number of units remains unchanged, but the value changes; this value change reflects the earnings obtained by the investor, but for tax purposes, it is considered capital gains rather than ordinary income obtained through additional units.
To facilitate this time-based value growth, protocols typically require additional steps to package the relevant cryptocurrency into an enhanced version of the original cryptocurrency to achieve time-based value growth. It is currently unclear whether these tax-efficient products can withstand scrutiny from the US Internal Revenue Service (IRS), as specific provisions for traditional financial products have been listed in Section 1258 of the tax law, prohibiting methods that convert income into capital gains.
Are DeFi Transaction Fees Eligible for Tax Benefits or Exemptions?
When transferring cryptocurrency between blockchains, entering or exiting DeFi protocols incurs transaction fees, commonly known as miner fees or transaction fees.
According to tax law, the treatment of these fees is essentially divided into two categories:
- Fees directly related to acquiring or selling cryptocurrency
- Fees charged for "transferring cryptocurrency between blockchains," considered part of investment activities
Tax Benefits
Fees directly related to acquiring or selling cryptocurrency will be included in the cost basis of acquiring cryptocurrency or used to offset gains from selling cryptocurrency.
No Tax Benefits
If fees charged for transferring cryptocurrency between blockchains are considered part of investment activities, there are no tax benefits.
免责声明：本文章仅代表作者个人观点，不代表本平台的立场和观点。本文章仅供信息分享，不构成对任何人的任何投资建议。用户与作者之间的任何争议，与本平台无关。如网页中刊载的文章或图片涉及侵权，请提供相关的权利证明和身份证明发送邮件到support@aicoin.com，本平台相关工作人员将会进行核查。
