Yield farming offers crypto investors a means to maximize gains from their portfolio. But the strategies are vast and complex and may have big tax implications. Learn about yield farming and how it’s taxed.
Making more crypto with your crypto? Sounds like every HODLers dream.
Yield farming lets investors do precisely that. It sprung up out of the DeFi movement and investors have pumped millions of dollars into the market since.
We’re looking at what yield farming is, how it works and what it means for your taxes.
What is Yield Farming?
The Decentralized Finance (DeFi) movement is revolutionizing the blockchain space. Anyone with an internet connection and a crypto wallet can use them. With no need for intermediary parties like crypto exchanges or regulations to follow - the rewards are bigger than ever.
Put simply, yield farming is putting your idle crypto assets to work to earn you passive income. It doesn’t refer to one specific strategy - like liquidity mining. Rather, crypto yield farmers chase the largest returns by moving their assets around various DeFi platforms that are offering the best APY or return for their investment. So yield farming is an all-encompassing term for a variety of crypto transactions.
Yield farming strategies vary in complexity. They can range from simply putting your asset in a given liquidity pool and letting it do its thing to earn you liquidity pool tokens to later sell all the way up to staking multiple DeFi protocols to reap the highest returns. That’s quite a mouthful so let’s break it down.
Composability refers to the interoperability of DeFi protocols. Essentially, different protocols can work together. Yield farmers can 'stack' these protocols to get the highest yields possible.
This is easier to understand with an example - let's use Alchemix. This DeFi platform offers self-paying loans. All an investor does is deposit DAI in the Alchemix vault, receive the set loan in return, then leave the original deposit in the vault to regenerate the loan amount. You can even then take that loan and invest it in another DeFi protocol.
Sounds simple, but free loans is a simple way of putting it because there's actually multiple DeFi protocols at work here.
The base layer protocol is Ethereum. That's the blockchain Alchemix and other DeFi apps are built on.
The next protocol is Maker DAO. Maker mints DAI - a stablecoin that is pegged to a dollar. Using DAI means Alchemix can manage volatility and ensure they can make the money back on loans.
Once you've deposited DAI into your Alchemix Vault, the Alchemix protocol starts loaning your deposit to other protocols like Yearn or Sushi. These are the yields that pay back your loan amount.
Of course, you've then got the option to then go on and reinvest your loan into another DeFi protocol - or multiple. This is known as compounding and there are even DeFi protocols that will automatically do this on your behalf.
This composability of DeFi protocols is what allows yield farmers to reap such high rewards. Alchemix is just one example - the DeFi movement is constantly innovating and creating new opportunities for investment. Yield farming is very competitive and investors tend to move between protocols quickly as when more yield farmers invest, the yield will decrease.
Popular Yield Farming Protocols
As you can see, there’s no one size fits all approach to yield farming. In fact, yield farming strategies are often kept secret to ensure other investors don’t follow suit. This said, there are several DeFi protocols, out of the hundreds available, that have a good reputation and many yield farmers use. These include:
- Maker DAO: a protocol for minting fiat-backed stablecoins.
- Aave: A crypto lending platform including flash loans.
- Compound: an instant crypto lending and savings platform.
- Yearn: a high yield crypto savings account using automated yield protocols.
- Curve: a stablecoin exchange platform.
- RenVM: a multi-chain protocol linking BTC to ETH.
- Sushi: a crypto exchange and hub.
- Synthetic: a derivatives liquidity protocol.
Yield farming can almost sound too good to be true, but you also need to understand the tax implications around it.
How is Yield Farming Taxed?
DeFi is a new phenomenon, which means most tax offices haven’t yet issued specific guidance on yield farming taxes. Before you jump for joy, that doesn’t mean yield farming isn’t subject to tax. Rather, investors need to take the current crypto tax rules in their country and apply it to their yield farming transactions.
Yield farming is built up of multiple transactions which are already covered in crypto tax rules. In fact - from a tax perspective, it’s pretty straightforward. Your crypto transactions will either be seen as a kind of income - and subject to Income tax - or as a capital gain - and subject to Capital Gains Tax. You just need to figure out how the tax office would view your different yield farming transactions.
Income Tax on Yield Farming
From a tax perspective, income is anytime you’re seen to be ‘earning’ crypto - like a regular income. Examples of crypto income that exist in current crypto tax guidance include:
- Mining crypto.
- Staking rewards.
- Being paid in crypto for a service.
Even new coins or tokens from an airdrop or a fork are considered income in some countries. All of these would be subject to Income Tax for the fair market value at the point you receive them.
There are many transactions in yield farming that could be viewed as income. For example, you might earn crypto in return for depositing an asset into a liquidity pool. Alternatively, you might earn new liquidity pool tokens for depositing your asset into a given pool. The point is - you’re receiving new coins or tokens as a reward - which is likely to be viewed as income and subject to Income Tax.
Capital Gains Tax on Yield Farming
Crypto isn’t seen as an actual currency by most countries. Instead it’s viewed as an asset - like a stock. From a tax perspective, this means many of your crypto transactions are viewed as a ‘disposal of an asset’ and subject to Capital Gains Tax. Examples of crypto disposals include:
- Selling crypto for fiat currency.
- Swapping crypto for crypto.
- Spending crypto on goods or services.
- Gifting crypto (in most countries).
So anytime you sell, swap or spend crypto in the course of yield farming - this would be subject to Capital Gains Tax. For example, if you sold liquidity pool tokens that you earned, or you swapped crypto assets - these transactions would be subject to Capital Gains Tax.
You won’t pay Capital Gains Tax on your entire investment, only any profits as a result of these transactions.
Check your crypto tax rules
Most tax offices have a similar view on crypto taxation, but you should always check your country’s specific crypto tax rules as there are small differences between them all. You can find out more in our crypto tax guides:
As well as this, our DeFi Tax Guide has more helpful advice on how different DeFi transactions are taxed.
Calculate crypto taxes with Koinly
Koinly calculates your crypto tax for you. All you need to do is sync the wallets, exchanges or blockchains you use and Koinly will import your crypto transaction data. From here, it will identify the different transactions and calculate your income, capital gains and losses and expenses.
All this information is summarized for you on your tax reports page. You can also download a variety of specific tax reports, ready to submit to your tax authority.
- Yield farming allows you to earn passive income from your crypto assets.
- It's an all encompassing term for a variety of strategies to maximize profits from your portfolio.
- Investors can use multiple DeFi platforms together, to maximize their returns.
- Yield farming doesn't have specific tax rules yet - but that doesn't mean it isn't taxed.
- If you're earning income through yield farming - this will be subject to Income Tax.
- If you're making a gain through yield farming - this will be subject to Capital Gains Tax.
- You should check your country's specific crypto tax rules and speak to a tax advisor.