Tax Time: How To Report Earnings From DeFi Protocols
Tax season is here again, and if you’re lucky, you might have some gains to report. Most people are becoming more familiar with the tax implications of trading crypto, but some aspects are still totally unexplored. At TokenTax, we’ve spent a long time analyzing the tax liabilities of cryptocurrencies, including for unique protocols like decentralized finance.
Decentralized Finance, or DeFi, is a big deal in the Ethereum world lately. Decentralized options are being developed for traditional financial functions, such as lending, borrowing, derivatives, insurance, payments, and more. You may have even participated in or utilized these decentralized financial tools. If so, it is a good idea to understand the tax implications of each and every step, just so you have all your bases covered.
In this article, we’ll take a look at one project in particular – Uniswap – a decentralized protocol for exchanging ERC20 tokens, and the tax implications for the various ways you can interact with the protocol.
Note: this is not official tax advice, as the IRS has not provided any official guidance regarding interacting with decentralized financial protocols. Please confirm any advice with your CPA.
What is Uniswap?
Uniswap is a decentralized exchange which runs 100% on the Ethereum blockchain. This means that unlike other exchanges, Uniswap runs completely via smart contracts.
It allows you to trade ERC20 tokens or ETH without an intermediary, and also allows you contribute to the exchange’s liquidity pool and earn passive income in the form of exchange fees.
Here are 5 ways you can interact with Uniswap:
- Deposit ETH or an ERC20 token in the liquidity pool, where you earn liquidity tokens to track your pool share and gain commission (split between all the liquidity providers)
- Trade your liquidity tokens while your deposit is still in the liquidity pool
- Trade ETH for an ERC20 token
- Trade an ERC20 token for ETH
- Trade an ERC20 token for another one
Let’s take a look at the tax implications of each one.
Depositing into liquidity pool
This is most likely not a taxable event because you are simply lending your coins/tokens to the liquidity pool. You are not selling them, and you still own those crypto assets. You could think of this like taking out a home-equity loan against a home that you own.
Trading your pool tokens
Uniswap allows you to trade your liquidity pool tokens, enabling transfer of pool share ownership without removing any liquidity from the pool. This is a taxable event because it involves a trade. The cost basis would be the commission that you earn from the liquidity pool tokens. Any further trades of liquidity pool tokens would have a gain or loss relative to that commission/income.
You can think of this as similar to mining cryptocurrencies, which counts as income. Your cost basis is set at a fair market value when you first receive the coins, followed by a capital gain or loss when you sell your mined coins.
However, we have seen some arguments for not reporting liquidity token income when earned due to the difficulty in tracking it, and instead reporting the full gain with a $0 cost basis when it is eventually sold. This is definitely a more conservative approach that also works.
Trading ether for an ERC20 token
This is a taxable event and would be treated like if you used any other crypto exchange. Your ETH position has an associated gain or loss depending on the USD amount you acquired it for.
Trading an ERC20 token for ether
This is the same as above ETH -> ERC20, just in the other direction. Your ERC20 tokens have a corresponding gain/loss depending for the equivalent USD amount you acquired it for.
Trading an ERC20 token for a different ERC20 token
This one is actually not as straightforward as you might initially imagine, because this type of trade counts as two separate transactions. For a user of Uniswap, it looks like just one trade.
However, the smart contracts execute two trades: ERC20 to ETH, and then from ETH into the second ERC20. Both of those trades are taxable events, although the second will likely have less of a tax liability since there usually is not much elapsed time between the two transactions. In cases of extreme volatility, the tax liability incurred could be greater.
Decentralized Finance is a unique application of cryptocurrencies and blockchain. However, the tax implications have not been analyzed as much as other crypto activities like mining or airdrops. That’s why I hope this article helps spur some more discussion and analysis on how various DeFi activities should be treated from a tax perspective.
The author is a co-founder of TokenTax, an accounting platform for crypto investors. Crypto Briefing does not accept any payment or financial benefit from expert guest authors.
If you are a blockchain expert with an interest in sharing your knowledge and experience, please contact our Managing Editor, Jon Rice, via email at editor AT cryptobriefing.com