Decentralized Finance (DeFi) is red hot, but what are the tax issues?

During the latest bullish run for bitcoin and crypto, the rise of Decentralized Finance (DeFi) applications and use cases has been an interesting parallel to the wider adoption and maturation narrative. Bitcoin continues to make the majority of headlines, either via price volatility or the introduction of bitcoin exchange traded fund products, but that is only one singular component of the broader story.

Put another way, as dynamic and interesting as bitcoin news is for discussion purposes, the cryptoasset sector has moved far beyond just focusing on any one specific coin.

On top of the continued maturation and development of many other cryptoasset options, there has been a trend toward centralization in the cryptoasset sector. This might seem paradoxical, given the original ethos and that the idea of crypto was to decentralize and democratize access to financial products and services, but is a logical extension of market trends. In order to achieve the scale, possess the authority to converse with regulators on a continuous basis, and offer the array of products and services that individual and institutional customers expect, a pivot toward more organized firms is logical. Examples of this centralization include Coinbase – a centralized crypto exchange that is rapidly becoming a household name – and the majority stablecoin sector, the vast number of which are issued and managed directly by a singular entity.

A direct response to this centralization has been the rapid rise and proliferation of DeFi, seeking to offer more decentralized options to market participants, while providing attractive rates of return to investors. However, those rates of return also bring about taxable income and tax obligations that need to be assessed, reported, and paid correctly. Prior to diving into some of the tax issues and open items for practitioners to consider, here’s a working definition of DeFi:

DeFi is, at the core of the idea, an attempt to replicate banking products and services (lending, borrowing, and earning interest) without the need for traditional financial institution.

Let’s take a closer look at some of the thornier tax issues and themes connected to the DeFi space.

 No DeFi specific guidance. First things first. There is no specific DeFi guidance that has been issued by the IRS as of this writing, and the probability of any being issued before the end of year is around 0%. Any advice received around DeFi tax issues is based on applying existing ordinary income and capital gain rules to DeFi operations.

Crypto lending has two options. Crypto lending – one of the first use cases for DeFi that enables users to earn returns on providing capital to other crypto users – can actually be treated two different ways, depending on the platform. On the one hand, if an investor earns returns from receiving payments directly from lending platforms (lending ETH and earning ETH), that is normally treated as ordinary income.

An extra layer is added, however, if the platform itself issues its own native tokens that leads to the providing of capital (liquidity) to be treated more like a token swap versus lending operation. In these cases, these earnings may be treated and taxed at the capital gains rate. You’ll want to make sure you always ask platform representatives for information.

Token treatment is the same. As DeFi operations continue to expand, and the competition for funds continue to increase, a new branch of available tokens has developed: governance tokens. Whether these governance tokens are issued as a component of yield payments or issued in return for other services, the premise is that these tokens function differently from other tokens derived from DeFi operations.

As far as current tax guidance is concerned, governance tokens are treated as the equivalent of other cryptoassets, in terms of criteria for how ordinary or capital gain taxes are determined.

Liquidity pools are still ambiguous. A rising area of prominence in the DeFi sector has been the increasing proliferation and prominence of liquidity pools, a method by which any investor can provide capital (liquidity) to decentralized marketplaces. In return for providing this capital to these decentralized marketplaces, investors receive tokens that represent a proportional interest in the pool. How these initial exchanges are treated for tax purposes should be determined only after consulting with a tax professional who’s familiar with your investing strategy and financial situation.

Income derived and earned from these pools is 1) ordinary income if investors have direct access to the underlying assets and receive interest on them, or 2) if the balance of tokens remains constant but does reflect changes in value as a result of exchange operations and fee generation.

Other tokenized assets are taxable. One other fact to keep in mind is that other tokenized assets – whether connected to virtual assets or tangible assets – are generally treated the same as other cryptoassets for income tax purposes. In other words, just because a tokenized product like governance tokens is marketed or developed differently, that has no bearing on its tax treatment.

The tax issues and questions around DeFi are just beginning to come to the surface, with emerging questions on liquidity pools, collateralization of crypto to unlock liquidity, and other applications still operating without any tax guidance. However, even without DeFi specific guidance, there are general themes and trends that practitioners should keep in mind as DeFi operations and options continue to move to the forefront.

DeFi is here to stay, with an increasing number of organizations offering services in this space. Practitioners will be well-served to realize crypto taxes are far from simple, and that the issues continue to evolve alongside the marketplace at large.