DeFi platforms offer unique opportunities for investors to loan their crypto assets and earn passive income, as well as borrow using their assets as collateral. But these transactions may have big implications come tax time. Let's look at what those might be.
HODLing your crypto to let it appreciate in value isn’t a new concept by any means. But many investors realize there’s little benefit in your crypto sitting in a cold wallet waiting for the day it finally goes to the moon.
Instead, what if you used your held assets to earn passive income and grow your portfolio? Or what if you could use your assets as collateral so you could make more investments?
Crypto lending lets investors do just that. While centralized exchanges like Binance have offered crypto loans for some time - DeFi crypto lending removes the need for an intermediary party - giving investors more control over their assets.
As with all crypto transactions, your tax office will want to know about your involvement with crypto loaning and any profits or income.
Crypto loans have been available on centralized exchanges like Binance, BlockFi and Nexo. Especially at the start of the pandemic when funds were low for many people, these loans grew in popularity. This is because unlike a loan from a bank - borrowers didn’t need to have their credit score assessed. As well as this, repayments are more flexible, interest rates are often lower and many loans are instantly approved.
While there are many benefits to crypto loans on centralized exchanges, there are also some disadvantages. Centralized exchanges must follow some regulations to be compliant. So they still have to follow Know Your Customer (KYC) procedures. As well as this, to protect against volatility, the loans are often overcollateralized with a high loan-to-value ratio.
On the flipside, there are decentralized exchanges (DEX) like Uniswap and Aave, and decentralized autonomous organizations (DAO) like Maker Dao. DeFi DEX and DAO crypto loan transactions are handled via smart contract code rather than an intermediary 'central' third party. Because there’s no middleman, users typically don’t need to complete KYC verification or lengthy paperwork. Anyone, anywhere can borrow.
As well as this, because the intermediary party doesn’t need to take a cut, many DeFi loaning platforms offer better gains for investors loaning their assets.
Using smart contracts is appealing to both lenders and borrowers. These self-executing contracts have the terms of the loan written into the code. All of this information is available for anyone to see on a distributed, decentralized blockchain network.
Loaning crypto on popular DeFi platforms offers investors a relatively risk-free means to make passive income from their assets. All they need to do is pick a DeFi platform, create a wallet and pick a lending pool to invest in, then reap the rewards.
Then there’s borrowing. On the surface, it might seem like you’d only borrow crypto when you really need the extra cash. While this does happen, many investors are borrowing crypto to increase their liquidity, so they can make other investments - in other words, for margin trading.
In either case, it allows investors to make the most of their held assets.
As with all crypto investments though - you need to be aware of the tax implications around loaning and borrowing crypto.
DeFi is so new that most tax offices haven’t actually got around to issuing specific guidance on it just yet.
Instead, investors need to carefully study their existing crypto tax laws to understand how their DeFi cryptocurrency activities may be viewed from a tax perspective. For this reason, it’s always advisable to speak to an experienced accountant to ensure you’re compliant.
In general though, your crypto transactions will always be seen one of two ways from a tax perspective. Either you’re earning an income and you’ll pay Income Tax or you’re making a capital gain and you’ll pay Capital Gains Tax.
Examples of earning an income include:
Examples of making a capital gain include:
So while there’s no clear guidance on DeFi crypto lending taxes, there is plenty of guidance on how similar transactions would be viewed from a tax perspective. Let’s break it down into the different transactions.
Loaning crypto on DeFi platforms may be subject to either Income Tax or Capital Gains Tax - depending on the exact platform you’re using and how it works.
When you loan crypto, you put your asset into a lending pool. This in itself would not trigger a taxable event - you’re not earning and you haven’t gotten rid of your asset and made a capital gain.
However - if you receive a coin or token to represent your share of the lending pool like UNI - this may trigger a taxable event. Some tax offices may view this as swapping crypto for another crypto - which would be subject to Capital Gains Tax.
Of course, the aim of the game when lending crypto is to earn interest on it. Again, how this is taxed will depend on how your specific DeFi platform works.
If you’re earning interest in the same cryptocurrency that you added to the lending pool, say via Compound - this would be seen as income and subject to Income Tax.
However, many DeFi platforms have changed tact and now investors earn through tokens on the platform. For example, on Aave, if you’re earning a given amount of AAVE tokens due to your assets in a loaning pool - this would also be subject to Income Tax. You’re earning new coins or tokens in exchange for a service - like any other income.
Another approach is where DeFi platforms only give you one token in exchange for your asset in a liquidity pool. This asset increases in value the longer you leave your funds in the pool, but you don’t earn any new tokens. You’ll only realize a profit when you remove your funds from the liquidity pool by exchanging your token back for your original capital. This would be a realized gain - you’ve made a profit by exchanging assets. Any profit from this would be subject to Capital Gains Tax as opposed to Income Tax.
What about tax from the other end of the spectrum - do you need to pay taxes when you’re borrowing crypto?
Like the above, this breaks down into several different transactions that we already have some guidance on from a tax perspective.
When you take out a crypto loan - you might need to put up collateral for the loan. Provided you didn’t receive a different token in return for your collateral - this wouldn’t be a taxable event. You’re not earning or making a capital gain. Your collateral is merely being held in a given wallet.
You’ll pay interest on the crypto you borrow in most instances. Paying interest in fiat currency is not a taxable event. Paying interest in crypto may be subject to Capital Gains Tax and it could be viewed as spending your crypto. If you’re taking out a loan for personal use - loan interest is not tax deductible.
However, in some instances - like if you’re viewed to be operating as a crypto business - if you’re taking out a loan for a commercial purpose, this loan interest could even be tax deductible. Similarly, if you’re operating as a day trader and you’ve borrowed for investment purposes - like yield farming - loan interest could be viewed as an investment interest expense which is tax deductible.
What about the funds you borrow? Well, it all depends on what you borrow and how you use it.
If you’ve borrowed fiat currency (or an equivalent stablecoin) with crypto as your collateral, you can use this currency however you want without triggering any taxable event as you won’t recognize any capital gains using these currencies. This is a great way for investors to avoid Capital Gains Tax legally.
If you’ve borrowed crypto to further invest, any of these investments will follow the same crypto tax rules that already exist. So if you’re selling, swapping or spending crypto - any gains would be subject to Capital Gains Tax.
Similarly, if you’re borrowing crypto to increase your yields through margin trading - any realized gain at the point you close your position would be subject to Capital Gains Tax.
Lending and borrowing crypto? Koinly calculates your crypto taxes for you - whatever crypto investments you’re making. You can find specific guidance on how Koinly deals with crypto loans here.
All you need to do is import your transactions from your crypto wallets and let Koinly do the rest. It’ll calculate your income, capital gains and losses and expenses for you. You can find all this information in an easy to read summary on your tax report page, as well as specific tax reports to download and submit to your tax authority.