Whether you’re an early cryptocurrency adopter or hearing about it for the first time, decentralized finance (DeFi) represents a fundamental shift in the way we interact with financial systems.
With close to $100 billion in capital, DeFi is capturing the attention of everyone from hobbyist day traders to large financial institutions to regulators.
Given the IRS’s lack of guidance in the space, and the approaching deadline for 2021 tax returns, DeFi participants and practitioners alike may be wondering how to consider these new transactions from a tax perspective. Below we explore some of the common questions around DeFi and taxation to provide participants and practitioners with a practical guide to navigating this new world, with an emphasis on liquidity providers.
What is DeFi?
Decentralized finance is a term for the rapidly growing global ecosystem of peer-to-peer financial applications built around blockchain and cryptocurrency technology and designed to serve as the foundation for an internet-native financial system. DeFi applications (DApps) and protocols enable a variety of “traditional” financial services and activities while reducing reliance on centralized financial intermediaries, not unlike the way Kayak and other travel search engines have supplanted the role of travel agents. Most DApps are built on self-executing code, or “smart contracts” which provide the functionality, programmability and automation to facilitate transactions on the platform. The DeFi ecosystem includes protocols and DApps for decentralized asset exchanges (DEXs), lending and borrowing, insurance, and derivatives trading, asset management, and yield farming, among other activities. Perhaps the most prevalent among these are protocols used by individuals and digital asset-native institutions for swapping different assets to meet liquidity needs.
How does DeFi differ from our current financial system?
While at first glance, many activities in DeFi may appear similar to the offerings of traditional financial institutions, DeFi is defined by the open, permissionless and interoperable access it provides. That is, virtually anyone can connect their digital asset wallet and begin participating, regardless of geographic location or affiliation with traditional financial institutions.
Who are the different participants or stakeholders involved in the DeFi ecosystem?
DeFi has several different stakeholder groups. First, the protocol, or DApp itself, serves as the backbone of the platform, automating the exchanges of assets between participants. Governance of the protocol is typically administered by users holding governance tokens (cryptocurrency tokens which can function like voting shares of a corporation). Participants can either provide/lend assets (liquidity providers) or take/borrow assets (liquidity takers). Each of these different parties plays a role in the functioning of the protocol.
One of the easiest avenues to participating in the DeFi space is as a liquidity provider. LPs are vital to the DeFi ecosystem, particularly for decentralized exchanges, because LPs provide the asset liquidity for transactions taking place on the platform. Typically, LPs deposit assets into liquidity pools, which other protocol participants can draw on for asset swaps or trades based on the current ratio of assets in the pool. Assets are exchanged via automated market makers (AMMs), or smart contacts that allow the permissionless flow of assets between the liquidity pools and participants. In exchange for providing liquidity, LPs are paid a reward or yield. Liquidity can be added or subtracted at any time, so the LP’s ownership percentage of pooled assets and the potential revenue earned can vary on a block-by-block basis.
How has the IRS viewed DeFi from a tax perspective?
While the IRS has yet to opine on DeFi activities directly, it has issued broader guidance on digital assets. Generally, the assets transacted in the DeFi space, including cryptocurrency, fall under the definition of virtual currency (VC), which the IRS views as property for income tax purposes. As with other types of property, taxpayers must report gains and losses on a sale or exchange. A sale or exchange may occur when there is a change in dominion and control over the asset. A simplified view of whether someone has “dominion and control” is whether that individual can freely sell or transfer that asset. However, taxpayers may be able to argue that no sale or exchange occurs when they receive substantially the same property back at the end of a transaction (e.g., certain crypto lending situations).
Taxable gain or loss is computed by subtracting the taxpayer’s basis (generally the fair market value, or FMV, at the time the asset was received plus fees or other costs) from the amount realized (generally the FMV at the date of sale). VC received by a taxpayer as a reward (such as mining or staking) or as an airdrop (including unsolicited) is treated as an accession to wealth and is taxable income based on the FMV on the date in which the taxpayer has dominion and control.
As an LP, what events could be considered taxable?
Events throughout the lifecycle of the LP’s participation should be evaluated for taxability. The specific facts and circumstances of each taxpayer, including review of the terms to which the LP and the agreed, should be carefully examined. Below are some activities and the potential tax considerations:
Initial contribution and return of the contributed assets, or loan and repayment of assets: Participation in DeFi generally involves a contribution of tokens from the LP in exchange for a token representing its contribution to the pool, for which the LP earns a yield or reward. On the surface, this can be perceived as akin to a more traditional lending arrangement. Given the IRS view of cryptocurrency as property, however, this initial contribution in exchange for a separate token could potentially be viewed as a taxable exchange of property under Section 1001 of the Internal Revenue Code.
One consideration is whether LPs can claim nonrecognition treatment under common law rules analogous to the securities lending rules of I.R.C. Section 1058. For the loan to qualify for nonrecognition treatment under Section 1058, the borrower is required to pay the lender the equivalent of all interest, dividends and other distributions to which the lender would have been entitled had it not lent the securities. It remains unclear whether substitute payments would be required or even feasible in the context of digital assets.
Upon return of the digital assets, a key consideration is whether the assets are considered “identical” to those contributed such that no taxable exchange has occurred. Interestingly, in 2021, the IRS included “contractual obligations that require the return of identical virtual currency” on its no-ruling list. If the returned VC is a different coin but the same general class of digital asset, and the second coin confers the same economic rights as the first, it is unclear whether those two tokens could be considered “identical.”
- Providing assets as collateral: This is likely not taxable, as the contributor retains ultimate ownership of assets in most situations.
- Token rebasing: Some tokens on DeFi protocols need to maintain a consistent value. These protocols have a built-in “rebase” function that makes an adjustment to the total supply of a token across all token holders and LPs, similar to a stock split in traditional finance. Such an event is likely not taxable, as the wallet supply of tokens changes but the total value owned remains the same and therefore no gain or loss is realized.
- Receipt of yield, interest or rewards (including governance tokens): Receipt of yield, interest or rewards will likely be treated as ordinary income and taxable when the LP achieves dominion and control over the reward — usually when “earned,” although taxpayers should look to the point in time in which they can actually sell or transfer the tokens.
- Wrapping tokens: Token wrapping is a process that adds more functionality or interoperability to cryptocurrency tokens, thereby enabling their use on non-native blockchains. In many cases, wrapping tokens can be analogized to exchanging cash for casino chips, whereupon the exchange of cash the value held by the user does not materially increase or decrease, but the user is now free to utilize that value in the variety of games on the casino floor which they could not otherwise access. The act of wrapping is likely not taxable but will depend on whether the token’s value materially changes.
What reporting is required of LPs for US income tax purposes?
Gains or losses are recognized by the LP and reported on Form 8949. Ordinary income from receipt of cryptocurrency (e.g., airdrops or “interest” payments) is reported along with other similar types of income on the taxpayer’s return. The determination of how the protocol or DApp is treated for income tax purposes could also inform or alter the reporting required of LPs. For example, if the entity is considered a partnership for income tax purposes, the LP may receive a Schedule K-1.
What about the new rules for digital assets in the recently enacted Infrastructure and Investment Act?
Beginning in 2023, cryptocurrency and other digital assets sold by customers of “brokers” will be subject to Form 1099-B reporting and cost-basis reporting. Taxpayers in a trade or business who receive payments of more than $10,000 in one transaction will be subject to Form 8300 reporting. While the definition of “broker” is currently very broad under the new law, the Treasury has stated that forthcoming regulations will clarify the definition’s scope.
At this time, it is unclear whether new broker reporting and transaction reporting rules would be feasible for DeFi participants who may not know the other party to the transaction. Recall that one of the core characteristics of DeFi is autonomous, permissionless transacting without an intermediary. It also remains unclear who would bear the responsibility of reporting (e.g., the LP or the protocol/DApp itself).
Despite a lack of new DeFi-specific guidance from the IRS, taxpayers can rely on existing rules to inform their tax planning. Because virtual currency is classified as property by the IRS, LPs may trigger one or more taxable events throughout their participation in DeFi. LPs need to consider the specific terms and economics of transactions in which they participate, as well as the nature of the assets they provide and/or receive.
