💸 A Handy Guide to DeFi Taxes

Hello Defiers! That not so joyful time of the year is here for US residents —the tax man is coming to collect.

As if this wasn’t enough of a pain to do the paperwork without crypto, actively trading in DeFi makes it even harder: How to treat LP tokens earned from adding liquidity in an AMM? What about interest from deposits in a lending protocol that’s accruing by block? Or token rewards from yield farming? And have you even considered what to do about NFTs?

Crypto tax expert Pat White has got us covered in today’s guest post.

Pat White is the CEO and Co-Founder of Bitwave, a platform specializing in software for businesses that use digital assets and crypto. Over the last decade, White has built enterprise software at companies such as Intuit, Microsoft, Five9, and Fortify Software (now HP Security). Later he co-founded Synata, an enterprise search platform that was acquired by Cisco in 2016, where he worked as the Chief Architect for their Webex Teams Product. Pat has contributed code to Bitcoin, Ethereum, and several other crypto-currency projects. He is also the co-host of the podcast, The DeFi Daily.

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The 2021 DeFi Tax Surprise

By Pat White

It’s that time of the year again. No, I don’t mean March Madness bracket busting, and I’m not talking about emerging from the depths of winter. That’s right, it’s the yearly time that we all get together and try to figure out how the heck we’re going to do our crypto taxes this year. And, boy oh boy did 2020 present some tricky new problems.

First - this column is not tax advice. Please consult with a tax lawyer or CPA before doing your taxes, and hey, it goes without saying, but always pay your taxes.

To start with - a refresher. Taxes on crypto actually aren’t that hard at a high level. They’re just like taxes on stocks or any other asset. When you buy some crypto, you get a cost basis. When you sell it, you get some proceeds. The difference between these two numbers (whether it’s gone up like my Bitcoin investment or melted through the floor like my XRP investment) is your capital gains or losses. For individuals in the US, if you hodl for more than a year, that’s long-term capital gains.

Things only get slightly more complicated if you get paid in crypto or spend crypto - you have to recognize the income you immediately receive (the fair market value of the crypto the day you get it) as normal income. Then, you have to keep track of the cost basis just like above for long-term gains and losses. This is tricky at scale, and the problem I started my company to solve.

Ok, let’s talk DeFi.

There are three big topics in DeFi we’ll discuss - liquidity pools, staking and yield farming, and NFTs.

Very simply, a liquidity pool, or a DEX, is a smart contract where you can exchange one token for another. Read more from The Defiant here. Trading on a DEX is exactly the same treatment as trading anywhere else. There is one level of complexity which is that Dex’s are 100% token to token trades, as opposed to exchanges where one side of the pair is often a fiat currency.

Liquidity Providing

But, let’s talk about the DeFi part - providing liquidity to a pool. I pick a pair (let’s say the SushiSwap WBTC / WETH) and I deposit 50% value of each asset. For instance, today that would be around 1 WBTC and 25 WETH. As part of that deposit, I get a token back indicating my ownership percent of the pool. People then trade against that pool, and over time my holding will shift in line with the relative movement of WBTC and WETH. Perhaps in a week my holdings will be with 1.1 WBTC and 24 WETH.

There are a few ways people are treating this for tax purposes. On the one hand, some people treat the initial deposit and token issuance as a trade. That is to say, you’re 100% disposing of the WBTC and WETH, and acquiring a new token with the cost basis of the tokens you disposed of.

For a lot of people, this is a perfectly reasonable treatment, especially if you only recently got into crypto. That’s because you pick up a gain or loss based on that disposition - if you've been hodling a month that might be a minor loss. If you’ve been hodling 5 years, you may be creating an enormous tax bill for yourself which would require you to liquidate assets.

To deal with that problem, some tax professionals are recommending you treat this as a containerization - the best analogy is to think of a blind trust. Back in the day, politicians would put their assets into a blind trust when they took office, which is to say they didn’t sell all their stock, but they put it under the care of a professional who would not consult with them on trades. Theoretically, this decreased the chances of the politician making self-enriching policy.

In that case, the transfer to the blind trust was not a taxable event, but every trade that the blind trust executed would be (even if you weren’t directing it).

That’s essentially what a liquidity pool is - you deposit some funds, then other people are actually doing the trading on top. So, in a perfect world, you’re not recognizing the transfer into the pool as a taxable event, you’re monitoring the trades and recognizing those on a block by block, day by day, or month by month basis. We build software to automate that, but you can do it yourself by just picking a time once a day to check your underlying asset balance in the liquidity pool, recording that in a spreadsheet, then having a column that tracks the relative deltas of the assets. Turning that into a trade can be simple for a 2 asset pool, perhaps more complex for a pool like Balancer, and you have to follow some rules around multi-asset trades.

In this way, you are essentially only recognizing the change to your holdings, not a full sale of all your deposited crypto. In fact, a similar discussion arises around WBTC and WETH - is the movement from ETH to WETH a sales and acquisition, or a containerization? Some tax professionals are ok with the containerized approach, some aren’t - so, talk to your tax person!

Yield Farming & ETH2

Great - what about staking and yield farming?

There are a lot of great articles about how to do taxes on mining revenue, and for the most part you can follow that guidance for staking and yield farming as well. Let’s take the above example - I want to deposit my SLP token and earn some SUSHI yield on that. Because you retain full control over those staked assets, and can remove them any time, you can really think of this as a bank account that’s earning interest. There is then the same debate about the staking rewards as there already exists about mining - namely, do you treat it as income immediately when it hits your wallet, or do you treat it as a zero-cost basis item, and only pay tax when you sell it. The more conservative treatment is to treat it as income as it hits your wallet (either looking at the balance in the staking contract or when you claim it) - your tax authority wants their money, and they want it now - deferring is usually a more aggressive stance. But, as always, talk to your tax professional.

This applies to various forms of deposit contracts - Yearn / Harvest vaults, Compound / AAVE deposits, and other instruments that look and smell like interest-bearing accounts.

But, what about something tricky that I know everyone is thinking about - ETH2 staking? Well, that is a lot more complicated. Because you can only deposit into the ETH2 contract right now, and because there’s no concrete plan to enable withdrawals, and it’s up to a bunch of random people with GitHub screen names - this really feels like a non-callable loan. Like a loan to your brother-in-law, you can hope it gets repaid, but you shouldn’t be counting on it. Talk to your tax professional about how to treat it, but many tax professionals in the crypto space are saying not to recognize any of the ETH2 staking rewards until you can actually claim them.

NFTs

Alright, we’ve tackled liquidity pools, we’ve tackled staking and yield farming - how about NFTs? Well - this one is tricky. At a high level, they are an asset like anything else on the blockchain - you want to treat the acquisition of an NFT like other assets (see how we treat multi-asset transactions, for instance, if buying the NFT took some tokens, some WETH, and cost some fees).

But here’s where things get complicated - in the United States (and several other tax jurisdictions), collectibles are taxed differently than stocks and bonds. That is to say, they generally don’t have long term capital gains treatments. What does that mean for you? Well, and I’m sounding like a broken record, but talk to your tax professional. The treatment comes down to intent and use - did you buy a Steph Curry TopShot because he’s your favorite player and you loved the 3-pointer he was draining? That feels a lot like collecting. Were you putting money into a crypto bond to earn a yield? Not so much collecting (though, some crypto bonds have really pretty digital designs, which definitely starts to muddy the waters). It gets even more tricky if you’re a business that’s actively trading NFTs, that feels more like normal business operations rather than collecting, but boy does it get gray. Tax professionals are your friends!

Finally, if you’re creating NFTs to sell, and selling them for a profit, that’s just like any other artist and you probably need to pay income taxes on them.

There are some things we haven’t covered (like lending pools, how to record losses from hacks, and what to do about token vesting periods), but this should get you started down the path of paying your taxes. And please remember - pay your taxes.

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