Liquidity Mining Taxes: How Are LP Tokens Taxed?
Liquidity mining is commonplace in DeFi, but the tax treatment all comes down to the specific protocol you're using. Learn more in our expert guide.
How is liquidity mining taxed?
Many tax offices, including the IRS, have yet to release guidance on the tax implications of liquidity provision. This doesn't mean it's tax-free, though. It just means investors need to interpret the current guidance as it applies to their protocol and transactions.
Liquidity mining basically breaks down into three different transactions:
Sending funds to a liquidity pool
Removing funds from a liquidity pool
Being rewarded with a given token
How is depositing in a liquidity pool taxed?
When you deposit to a liquidity pool, you'll receive LP tokens representing your asset in the pool.
This is akin to a crypto-to-crypto trade, which is a taxable disposal, and any profit is subject to capital gains tax.
Example
You provide 600 USDT & 1 BNB to a Uniswap USDT/BNB pool. You receive USDT-BNB LP tokens.
You've disposed of your 600 USDT & 1 BNB tokens, and any gain as a result is taxable.
The sale price of your USDT and BNB tokens is now the cost basis for your USDT-BNB LP tokens.
How is removing tokens from a liquidity pool taxed?
Like depositing your funds, when you remove your funds from a liquidity pool, you trade back your LP tokens. Again, crypto trades are taxable disposals and profits subject to capital gains tax.
How are liquidity mining rewards taxed?
This is probably the most complicated transaction from a tax perspective, because it all depends on the specific protocol.
This is because different DeFi protocols reward users in different ways.
For example, Compound’s cToken is given to all liquidity providers in exchange for their asset(s). When you ‘earn’ cTokens, you don’t actually receive more cTokens. Instead, the value of your cToken(s) will increase the more active the liquidity pool is.
When you then exchange your cTokens back to the underlying asset, this is a disposal. You don't realize your rewards until the point you exchange your tokens. Profits in this example would be subject to capital gains tax.
But not all protocols work this way. For example, if you’re using Aave, you’ll receive aTokens for providing liquidity. You’ll receive aTokens at a 1:1 ratio to the underlying asset, so you’ll get more aTokens the larger your share in the pool. Because you’re earning new tokens, this would be classed as ordinary income and subject to income tax.
Some protocols will result in both capital gains tax and income tax implications, for example, if you're trading LP tokens and earning governance tokens for provision. Just remember:
Income tax: if you’re earning new coins or tokens.
Capital gains tax: if your balance of tokens stays constant, but increases in value.
How do I report liquidity mining on taxes?
You'll report your crypto transactions in your annual tax return:
Form 8949: Reports every single disposal of crypto. This would include trades for LP tokens.
Schedule D: Reports your net gain/loss from your disposals.
Schedule 1: Reports any miscellaneous income from crypto. This would include new tokens from liquidity provision.
How Koinly can help
Koinly has complete support for LP transactions across thousands of protocols and hundreds of chains. That means it can identify your cost basis for assets, calculate gains/losses from taxable disposals for LP tokens, track your cost basis for LP tokens, and calculate any income from rewards.
