Demystifying DeFi tax

In brief

The exponential growth of decentralized finance (DeFi) has brought access to, and interest in, these platforms to a wider range of users — from individuals to institutional investors and multinational organizations. The technology makes sophisticated finance transactions available to all kinds of users in a variety of locations.

Although other jurisdictions (e.g., United Kingdom) have started issuing tax guidance in this area, to date taxation of DeFi transactions has not been specifically addressed in published guidance by US tax regulators. As individuals and entities navigate this uncertainty, it is notable that all the characteristics that make DeFi transformative to the future of finance also are features that make it challenging to address from a US tax standpoint. 

We outline below the fundamental features of a DeFi ecosystem, and highlight how they can affect the US taxation of the transactions entered into through the ecosystem.  

The key takeaways are:

• DeFi is complicated. Each DeFi ecosystem is different, and the US tax results depend on the specific asset and the substance of the specific transaction undertaken. 
• Tax may be incurred in advance of selling the DeFi investment.
• The recordkeeping obligations to support US tax return reporting require transaction-by-transaction information that may necessitate gathering information from multiple sources.

Action item: Investors and traders should start now to gather relevant information to make these determinations with the goal of having sufficient time to identify US tax consequences. This is particularly important where such information is not stored in a centralized account or reporting technology, or where such reporting technology does not capture all relevant data to facilitate required US tax reporting.

What are the potential US tax consequences of these transactions?  

US income taxation generally is transactional — i.e., imposed at the time of receipt or sale of a token, with exceptions. In general, value fluctuations are not taxed between purchase/acquisition and sale (or disposition) of the token. Taxable events occur when a person does something with that token.

Timing of recognition of gain on transfers/exchanges: Although these platforms may use the terms “loan,” “lending,” and “yield,” the current US tax rules do not protect all loans of property from the recognition of gain.

• Exchanging one or more cryptocurrencies for a DeFi token (including minting new DeFi tokens, whether fungible or non-fungible tokens) may result in recognition of gain or loss at the time of the exchange. 
• Similarly, exchange of the DeFi token for one or more cryptocurrencies (including burning the DeFi token) may result in the recognition of gain or loss at the time of the exchange.

Observation: Under current tax law, these transactions are not covered by the rules that protect loans of securities from the recognition of gain or loss. There are legislative proposals to broaden such protection to cryptocurrency loans, but even if such a proposal were enacted, it might not cover most DeFi platforms as currently structured.

Timing of recognition of periodic income: Participating in certain DeFi protocols entitles the holder to receive, or have set aside/credited to their account, additional tokens (representing “yield” or a portion of the fees earned on the platform).  

The timing of income from these arrangements when paid in cryptocurrency is the subject of ongoing debate:

• If the arrangement is viewed as analogous to staking or mining income, the IRS might assert that the tokens are taxable upon receipt or when they may be freely claimed.
• Token holders may seek to assert that the amounts are not taxable until the token received is sold, a position the IRS has challenged in court filings.

Observation: This question is further complicated in the DeFi context because DeFi protocols differ as to when the tokens are received, may be claimed, or are restricted from receipt by the token holder. The more meaningful restrictions on the receipt of the tokens, the less likely the tokens may be viewed as taxable until such restrictions lapse.

Amount of gain or income: The amount of taxable income or loss realized upon exchanging cryptocurrency for the DeFi token (and return receipt of cryptocurrency when exiting the DeFi protocol) is measured based on the fair market value of the cryptocurrency and token received or disposed of at the time of the exchange. 

• Similarly, any periodic income from the receipt of tokens as “yield” or “rewards” should be included in income at the fair market value at the date/time the tokens are actually or constructively received.
• This requires detailed recordkeeping on the date/time of receipt or exchange, reliable fair market value information, and, for tokens acquired in an exchange, tracking the acquisition price or income picked up associated with the token to establish the basis in the token.

Observation: In many DeFi protocols, this information is not readily available and needs to be tracked separately by the taxpayer.

Character of income: The character of the income, deduction, gain or loss (which affects the tax rate applied and the items against which gains and losses can be netted) depends on the kind of income:

• Gain or loss from cryptocurrency exchanges related to DeFi protocols may be capital gain or loss if the asset is held for investment or trading purposes.
  • Because DeFi protocols often replicate the financial services rendered by “business entities,” there is risk that these may be treated as “business entities” under US tax rules.
  • If the DeFi protocol itself is treated as a non-US “business entity” from a US tax perspective, a portion of the income might be treated as ordinary income (and taxed at higher rates).  
• The periodic income (i.e., staking return or yield) may be treated as ordinary in character.  

Observation: Such treatment could result in a potentially unfavorable whipsaw if yield (paid in tokens) is included as ordinary income when the trading price is high and then the token is sold when the price has dropped, resulting in taxable ordinary income at a higher rate and an inability to offset that amount with the loss on the sale of the token (because capital losses generally cannot be used to offset ordinary income).