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Crypto Tax
DeFi Tax Guide
4 mins read

The Ultimate DeFi Tax Guide

MISHIKA
26 MAR 2022

Platforms for decentralised financing (DeFi) give investors a novel and exciting option to buy cryptocurrencies. These platforms offer a decentralised alternative to conventional financial institutions by establishing a decentralised monetary system that runs on a blockchain network. Investors must be aware of specific tax implications due to the growth of DeFi platforms.

The definitive DeFi tax guidance will be provided along with an examination of the tax ramifications of investing in DeFi platforms. Suppose you want to stay compliant and reduce your tax liability, regardless of whether you're an experienced cryptocurrency investor or are just getting started in the DeFi field. In that case, you need to understand the tax rules and techniques.

Understanding DeFi Taxes

Decentralised environments in which the DeFi platform’s function prevents any central authority from controlling transactions. Tax calculation may be complicated as a result of this error. However, investors must still record profits or losses on their tax returns. Determining the cost basis of DeFi transactions is one of the most significant issues, especially because many DeFi tokens are volatile and have a high potential for value fluctuations.

For taxation purposes, the cost basis of a cryptocurrency is its initial worth. For instance, your taxable gain would be $100 if you purchased a DeFi token for $100 and then sold it for $200. Yet, figuring out a DeFi token's cost basis might be complex because there is no monitoring.

Types of DeFi Transactions

Understanding the various DeFi transactions that can occur is crucial before delving into their tax ramifications. They consist of the following:

  • Trading cryptocurrencies: In this process, one cryptocurrency is exchanged for another, for example, Ethereum for Bitcoin.
  • Yield farming: This includes giving a DeFi protocol liquidity in return for rewards.
  • Lending and borrowing: Users can earn, borrow, and pay interest while lending their bitcoin to others.
  • Staking: This entails storing cryptocurrency in a wallet for a predetermined time in exchange for network security benefits.

We'll go into more depth about the various tax ramifications of each transaction below.

Tax Treatment of DeFi Transactions

For taxation reasons, the IRS in the United States regards cryptocurrencies as property. Capital gains tax is applied to all cryptocurrency DeFi transactions.

The tax on profits earned from the sale of an asset is known as capital gains tax. If you purchase 1 ETH for $100 and sell it for $200, for instance, you have achieved a capital gain of $100 that is taxable. To keep track of this data and get accurate reports, it’s suggested to keep your crypto wallets and crypto exchanges connected to a crypto tax calculator and keep track of all your crypto assets using a crypto portfolio tracker.

The holding time for the asset affects the tax rate. Short-term capital gains tax is applied to purchases kept for less than a year; long-term capital gains tax, often lower than the short-term rate, is used for assets held for more than a year.

Let's examine each form of DeFi transaction's tax repercussions in more detail:

  • Trading cryptocurrencies: Each transaction is considered a taxable event, and any profits are subject to capital gains tax.
  • Yield farming: Giving a DeFi protocol liquidity in return for rewards is seen as a taxable event. Capital gains tax is also owed when rewards are sold or traded for another cryptocurrency. The tips obtained are subject to income tax.
  • Lending and borrowing: Interest on bitcoin loans is taxable as income. Cryptocurrency interest payments may be tax deductible, but it's essential to speak with a tax expert to make sure.
  • Staking: When awards from staking are sold or exchanged for another cryptocurrency, capital gains tax is required in addition to income tax on the rewards.

Reporting DeFi Transactions on Your Tax Return

Knowing how to record these transactions on your tax return is crucial now that we've discussed the tax repercussions of various DeFi transactions.

All cryptocurrency transactions, including DeFi transactions, must be reported by taxpayers to the IRS on their tax returns and with valid crypto taxes forms. This means you must keep a record of every DeFi transaction you make throughout the year, including the date, the value, and the quantity of bitcoin involved. Penalties and fines may apply if DeFi transactions are not reported.

The latest version of the IRS's tax advice on cryptocurrencies, which covers DeFi investments, has just been released. You must disclose any gains or losses on your tax return if you sell or exchange DeFi tokens. You must declare the fair market value of DeFi tokens as income if you get them in exchange for products or services. For taxation reasons, the IRS views cryptocurrencies as property. Thus, every business or sale of a DeFi token is taxable. Each transaction's specifics, such as the date of purchase, the cost basis, and the date of sale, must be reported. Keeping thorough records of all your DeFi transactions is crucial to ensure proper reporting and reduce tax liabilities.

Tax Strategies for DeFi Investors

DeFi investors can employ various tax planning techniques to reduce their tax obligations. One tactic is holding onto DeFi tokens for over a year before selling them. You may be eligible for long-term capital gains tax rates, often less expensive than short-term ones. Using a tax-loss harvesting approach to offset gains from other assets is another tactic.

Selling failing investments to offset gains from other investments is known as "tax-loss harvesting." By investing in DeFi, you can sell lost DeFi tokens to make up for winnings from other cryptocurrencies. This method can lower your overall tax obligation and is especially beneficial for traders who conduct many trades.

Conclusion

DeFi platform investing can be profitable, but it's essential to comprehend the tax ramifications of these transactions. You can decrease your tax bill and maintain compliance with tax rules by adhering to the recommendations provided in this comprehensive DeFi tax guide. Keep thorough records of all your transactions, and if you have any questions or concerns, speak with a tax expert.

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