The IRS and DeFi taxes

The IRS puts digital assets used in DeFi under the same property rules that apply to other cryptocurrencies. Specific regulations for DeFi are scarce, but the usual guidelines (capital gains or income) still apply. Because official direction remains limited, investors should keep thorough records for each transaction to identify any potential taxable event.

DeFi platforms may have to start issuing forms (like Form 1099-DA) in the US at some point. If that plan goes forward, front-end protocols (including some DeFI crypto exchanges or lending portals) would need to gather user details. This shift highlights why diligence is so necessary. Pay attention to compliance, and document your transactions carefully.

Calculate your crypto gains with our free crypto profit calculator.

Relevant IRS tax forms for DeFi taxes

If these forms aren’t filled out correctly, you run the risk of penalties. Keep track of every transaction’s cost basis, market value, and whether the event is capital or income in nature.

How are DeFi transactions taxed?

DeFi activities usually fall into two main brackets:

• Capital gains: You realize gains or losses when disposing of one crypto asset for another. That can happen if you sell governance tokens or if you withdraw from certain protocols, often counted as a trade.

• Ordinary income: This applies to tokens received as a reward or bonus, such as staking crypto payouts, lending interest, or tokens you earn for providing liquidity.

Overview of DeFi taxes

The IRS hasn’t spelled out rules for every single DeFi transaction, but most scenarios mirror existing crypto tax practices:

• Trading on a decentralized exchange: Recognized as a capital gain or loss.

• Staking or yield farming: Taxed as ordinary income when new tokens land in your wallet.

• Liquidity mining: Treated as income at the time new tokens appear.

• Borrowing: Not generally taxed unless sell the collateral.

• Providing collateral: Potential capital gain if your original asset is swapped for a different token.

Minimizing taxes on DeFi transactions

• Hold assets longer: If you keep coins over a year, you may qualify forr a lower long-term gains rate.

• Offset with losses: If some tokens lose value, selling them can help balance out your capital gains.

• Select a method: DeFi actions like wrapping can follow a conservative or aggressive stance. Choose one that aligns with your risk tolerance.

• Use crypto tax software for DeFI investors: Automated solutions track data and may reveal opportunities to cut your tax bill.

Best practices for tracking and reporting DeFi taxes

• Record every detail: Note times, amounts, receiving addresses, and each asset’s market value.

• Document transfers: Moving crypto between your own wallets isn’t a taxable event, but you need evidence of ownership in both addresses.

• Ask experts: DeFi can be complicated. If you’re unsure, talk to a specialist who understands current regulations.

• Leverage the best crypto tax software for DeFI: Syncing automatically with DeFI swaps and other protocols can simplify data collection and reduce errors.

How does the IRS tax governance tokens?

Governance tokens typically carry voting privileges. They can also trigger tax obligations:

• Receiving governance tokens: Usually viewed as ordinary income. The amount you record is based on the token’s worth the moment you control it.

• Selling governance tokens: If you sell or swap tokens later, it counts as a capital gain or loss, depending on the token’s value at acquisition and disposal.

Governance tokens tax example

Suppose you gain $500 worth of governance tokens for participating in a protocol. You’d report $500 as income. If you sell them later at $700, the extra $200 is a capital gain, reported on Form 8949.

Use our free crypto tax calculator.

How does the IRS tax DeFi loans?

DeFi loans allow users to borrow tokens backed by crypto. Though they work similarly to bank loans, the volatility of digital assets can introduce extra tax considerations:

• Taking a loan: Borrowing alone does not create a tax event unless you have to trade collateral (like swapping ETH for another token to receive your funds).

• Forced liquidation: If your collateral is sold automatically to cover the loan, that transaction is a taxable event (a capital gain or loss).

• Interest deductions: The IRS hasn’t detailed how crypto loan interest works for write-offs. Traditional rules apply if the loan is used for business or investments.

See our expert picks of the best crypto loans.

DeFi loans tax example

Imagine locking up $3,000 in Ether. You borrow a stablecoin. If your Ether drops to $2,000 and gets liquidated, you have to recognize the change ($1,000) from your cost basis to that $2,000 figure.

Withdrawing liquidity capital gains tax example

Suppose you put in $2,000 of ETH, and your share is worth $3,000 by the time you exit. If you get $3,000 in ETH when redeeming LP tokens, you realize a $1,000 gain, assuming you started with a $2,000 basis.

How does the IRS tax bridged tokens?

Moving crypto between blockchains is called bridging. Generally, bridging does not represent a typical trade. You’re sending the same token across networks. In many cases, that’s seen as non-taxable because you retain ownership of the same asset in a different environment.

Still, some investors prefer treating it as a disposal. Most experts, however, classify bridging as non-taxable unless something else triggers a gain or loss.

How does the IRS tax wrapped tokens?

Wrapping tokens (turning BTC into a wrapped version on another chain) remains somewhat ambiguous. The IRS hasn’t issued official statements on this topic, so investors follow two usual methods:

• Conservative: Behave as if you traded one crypto for another, generating gains or losses based on price shifts.

• Aggressive: Treat wrapping as a technical step that does not change your underlying position. Thus, no gain or loss is recognized until a final sale.

How are DeFi airdrops taxed?

Some protocols send free tokens (airdrops) to users. These are generally counted as ordinary income:

• Receiving an airdrop: The fair value when the token arrives is recognized as income.

• Later disposal: Selling or trading an airdropped coin for another token typically produces a capital gain or loss, measured from the original value to the time of sale.

How does the IRS tax liquidity mining?

Liquidity mining requires users to deposit assets into a smart contract, often receiving liquidity pool tokens in return. Additional reward tokens may also be distributed.

Depositing liquidity: Capital gains

Exchanging your crypto for LP tokens is frequently viewed as swapping one asset for another.

Depositing liquidity capital gains tax example

If you acquired ETH at $1,200 and it’s worth $1,500 when you deposit it into a pool, you realize a $300 gain at that deposit step.

Withdrawing liquidity: Capital gains tax

Withdrawing assets means trading those LP tokens back to the original coin. This can trigger a capital gain or loss.

Conservative vs. aggressive tax approaches to liquidity mining taxes

• Conservative: Count contributions and withdrawals as taxable events, since you’re exchanging different tokens.

• Aggressive: Treat LP token acquisition as non-taxable. Any gains or losses get calculated only when you finally exit to your original crypto asset.

Can DeFi protocols be used for tax evasion?

Although the platforms are decentralized, they rely on transparent blockchain ledgers. The IRS has hired firms to monitor suspicious activity, so ignoring taxes is very risky. Over time, DeFi exchanges could face mandates to collect user data and send reports to the government. Attempts to hide DeFi earnings could invite serious trouble.

How TokenTax simplifies DeFi taxes

TokenTax supports various DeFi tasks, like DeFI swaps or depositing into liquidity pools, by capturing all your transactions in one place. Our crypto tax software for DeFI investors calculates your gains, determines cost basis, and prepares your returns. This helps you stay organized and reduces the stress of manual tracking. If you have questions, our team of crypto tax experts can help.