What is DeFi & How is it Taxed?

Crypto investors and enthusiasts have long speculated over the potential of blockchain technology and how it could revolutionize industries by removing the control large corporations hold over information and finances. Well, DeFi is here to do just that. In this guide, we're learning all about DeFi, how it works, how investors are using it and how DeFi is taxed.

Decentralized finance, or DeFi for short, is a blockchain-based form of finance that gives users access to financial services, without having to deal with centralized services like banks, brokerages or exchanges.

The potential for DeFi is huge. The financial systems we know now are limited by borders, a select few corporations and outdated technologies. Ultimately, this results in a lack of access to financial services for billions of people, as well as a lack of financial freedom.

DeFi is taking on centralized financial systems with global, decentralized networks that take the power away from intermediaries and put it in the hands of regular people.

We’ll be diving into everything you need to know about DeFi, how crypto investors are using it to make money and what the tax implications of DeFi are in this article.

This guide is regularly updated

Before we dive in... the DeFi space is constantly evolving and tax offices are playing catch up! We keep an eye out for any new guidance on DeFi crypto taxes from tax authorities around the world and regularly update this guide to help our users remain tax compliant.

2 September 2022: Updated with more guidance from tax offices
30 November 2021: Curve, Compound and Uniswap Tax guides added.
11 November 2021: Welcome to your DeFi tax guide.

What is DeFi?

DeFi isn’t just one concept. It’s an all-encompassing term for a variety of financial applications built using blockchain technology, or that use cryptocurrency. These apps are also known as DeFi protocols.

The aim of the game? Disrupt centralized financial systems - and make money in the process.

The term DeFi was coined in 2018, in a Telegram chat. A group of entrepreneurs and developers were trying to name the new automated, financial services they planned to build on the Ethereum blockchain. Inspired by Bitcoin’s concept of a decentralized currency and spurred on by the capabilities of smart contracts, the goal was simple - decentralized finance accessible to anyone with an internet connection.

Just three years from that point, the DeFi market has around $90 billion of collateral and millions of investors.

DeFi vs. traditional finance

One of the easiest ways to understand the principles of DeFi is to understand the problems with traditional finance that it hopes to solve.

Traditional finance is limited by:

• Centralized institutions that control markets.
• Internal human processes causing delays and errors.
• Limited trading hours based on specific time zones.
• A premium to access financial services to intermediaries can take their cut.
• A lack of accessibility to financial services for millions of people based on various regulations, rules and policies of corporations and governments.
• The hidden charge of holding and collecting your personal data.

All this to say, these are the problems DeFi is looking to tackle. It’s a tall order, but it aims to do this by:

• Letting users hold and have control over their own money and how it’s spent.
• Automating and speeding up transactions and processes using technology.
• Letting anyone, anywhere have access to financial services without holding or collecting their personal information.
• Creating borderless markets that are always open to investors.
• Creating transparency with public transaction records.
• Using a decentralized network to ensure no one corporation or individual has too much control.
• Democratic governance over the services offered and their development.

This is why the core tenets of DeFi are that it is non-custodial, open, transparent and decentralized.

What can you do with DeFi?

Now you know how and why DeFi was created, let’s look at what it can do. As we said above, DeFi isn’t one application or process - it’s a huge collection of different protocols. DeFi protocols are autonomous programs (smart contracts) that have been created to execute specific functions.

Many of these were created to tackle problems existing in the traditional financial sector. For example, if you want a loan with a traditional bank, you'll normally need to provide identification, proof of income, proof of where you live and fill out many forms. But with DeFi, all you need to do is deposit an asset into a given protocol that does this for you. The protocol dictates the terms, conditions and rules. If you're unable to make payments back, the protocol will liquidate the contract.

This is just one example of a DeFi protocol out of the hundreds that exist. You can do anything you can do through a centralized crypto exchange with DeFi protocols - and more. This includes:

• Send money to anyone, anywhere
• Stream money worldwide
• Start a savings account
• Exchange fiat currency, coins and tokens
• Manage and grow your financial portfolio
• Borrow funds with or without collateral
• Derivatives, margin and leveraged trading
• Loan your own funds to earn interest or rewards
• Access and invest in stable currencies
• Crowdfund new DeFi platforms, services and apps
• Get insurance
• Bet on the outcome of current events

The different DeFi protocols can be grouped into the different functions they serve. Let's look at some of the most popular protocols and what they do:

Decentralized Exchanges (Dexes)

Decentralized exchanges - like Curve, Uniswap and SushiSwap - offer the same services as centralized exchanges. The difference is instead of a third party - like Coinbase or Binance - acting as an intermediary between traders - dexes allow for peer-to-peer crypto trading.

Decentralized Applications (Dapps)

Dapps do whatever they're build to do - from games through to specific functions to help the DeFi space advance. A good example of this is Drife. Drife is a Dapp created to decentralize ride sharing - so cutting out the middleman like Uber or Lyft. With no intermediary party to take a cut, drivers can take the full fare and offer cheaper riders.

This is just one Dapp of thousands - but crypto investors can stake in these various apps to seek a return.

Lending Protocols

Once of the biggest investment trends that has sprung up out of the DeFi space is lending protocols. This lets investors lock their idle assets into lending protocols and earn interest. Each lending protocol works slightly differently so you might earn interest in the same cryptocurrency as your asset or in the form of a different token or coin. Some of the most popular lending protocols are Aave, Compound and Anchor.

Yield Protocols

We'll explain yield farming a little more below - but yield protocols are big business in DeFi. These protocols 'stack' other DeFi protocols to let investors earn the best yields on their idle assets. Examples of yield protocols include Yearn Finance, Convex Finance and Alchemix.

Staking Protocols

Staking exists in the decentralized crypto market, just as it does in the decentralized space. The principles are the same - investors stake a given asset and earn transcation fees or another reward for doing so. Popular staking protocols include Lido, Marinade Finance and Quarry.

Insurance Protocols

Worried about trading assets in a decentralized space? Insure them. There are many DeFi insurance protocols springing up to help build confidence in the market. Some popular insurance protocols include Armor, Nexus Mutual and Unslashed. Like with Dapps - investors can stake assets to earn from these projects.

Options Protocols

Just like you can trade options on centralized crypto exchanges like Binance - there are now DeFi protocols offering this too. Popular options protocols include OPYN, Ribbon Finance and Lyra.

Decentralized Indexes

A crypto index is a portfolio of coins or tokens that you buy, sell and swap altogether - as opposed to buying and selling each cryptocurrency in a given portfolio individually. Indexes let investors diversify their portfolio, reduce risk and regularly rebalance their investments to yield the largest returns.

With so many different protocols available, the DeFi crypto market has a real need for investors to be able to easily navigate the various opportunities and diversify and rebalance their assets regularly. Fortunately, decentralized indexes do just this and automate the process for investors. Some of the most popular decentralized indexes include Set Protocol, Index Coop and Enzyme Finance.

DeFi Protocol Examples

There are dozens of popular decentralized exchanges and lending platforms to choose from. Some of the most popular include:

Curve

Curve (CRV) is a decentralized exchange, built on Ethereum, that uses liquidity pools to allow investors to trade stablecoins with low fees and low slippage. Investors can earn from providing liquidity, as well as stake native asset CRV to receive trading fees.

Convex Finance

Convex is a specific protocol for CRV tokens that boosts yields for Curve investors.

MakerDAO

MakerDAO is a decentralized lending platform that lets users loan and borrow cryptocurrency in the native asset DAI, as well as earn by adding liquidity.

Aave

Aave is a decentralized money market protocol that allows users to lend and borrow cryptocurrencies. Users can get flash loans, earn by adding liquidity and more.

Compound

Compound is a lending protocol that allows investors to generate interest on their assets. Investors can borrow assets or earn by adding liquidity.

Lido

Lido is a staking protocol. Investors can earn by staking assets for daily rewards. In exchange, users receive a token representing their staked asset, which they can then go on to invest in other yield or lending protocols that work with Lido.

Uniswap

Uniswap is a decentralized exchange that works as an automated market maker by utilizing liquidity pools. Users can trade coins and tokens on the platform, as well as lend crypto to receive rewards. 

SushiSwap

Like above, SushiSwap is a decentralized exchange that lets users swap, lend and borrow crypto on the Ethereum blockchain

PancakeSwap

PancakeSwap is another decentralized exchange, but unlike the above two - it's built on the Binance Smart Chain - often offering lower fees and faster transactions than Ethereum. Users can buy, sell and swap BEP-20 tokens and earn CAKE tokens in return for providing liquidity. They can also stake CAKE in specific SYRUP pools to yield larger rewards.

Yearn Finance

Yearn finance is an aggregator service that functions as a yield protocol. What we mean by this is it's actually a group of specific protocols that run on the Ethereum blockchain. These protocols in combination let users earn the largest rewards from idle assets.

Balancer

Balancer is a protocol for programmable liquidity. This protocol is used as a building block for many other protocols - like Aave. It balances liquidity pools to ensure each pool has the correct proportion of assets to allow easy and safe trading. The smart contract automates this entire process through algorithms.

How do investors make money from DeFi?

We've touched on this above, but there's a huge amount of investment opportunities in DeFi. In fact, the total value locked in DeFi protocols currently stands at around $270 billion. There are endless ways to make money from DeFi protocols - but the most popular include staking, yield farming and liquidity mining, as well as advanced trading like derivatives, futures, options and so on. Let's take a quick look at each.

Staking

Staking is a concept that exists outside of DeFi in the form of proof of stake, as well as with centralized platforms like CoinBase. In short, investors can stake their assets into a given protocol and are rewarded with fees related to that protocol in return.

A a number of DeFi platforms like Polkadot are allowing users to stake their tokens and earn an annual percentage yield (APY) in return.  There are also dedicated staking protocols like Lido, Marinade Finance and StakeHound.

Yield Farming

Yield farming is a lot like staking, in that you're depositing an asset into a given protocol to earn a reward. The key difference is in the DeFi space, you can stack various protocols on top of each other to seek larger returns.

There are some yield protocols that do this for you automatically - like Curve and Convex Finance. All investors need to do is deposit their given asset into these protocols. However, some crypto investors create complex strategies to seek out even larger returns by researching different protocols and their interoperability.

Liquidity Mining

Liquidity mining is a subset of yield farming. It refers to adding liquidity to different DeFi protocol liquidity pools to earn rewards - much like yield farming. The key difference is that with liquidity mining - you're seeking out a reward in the form of the protocols native token like PancakeSwap's CAKE or Uniswap's UNI token. While many of these tokens were originally created as governance tokens - to give users a say in the development and management of the protocol - many of them have soared in value, making them very desirable to investors.

Play to Earn DeFi Games and Gamified DeFi

Investors can earn tokens by playing DeFi games. For example, Axie Infinity users can earn SLP by battling monsters, other players and completing daily quests. This is what's known as the play-to-earn model. There are many examples of DeFi protocols adopting this including:

• Dencentraland
• Coin Hunt World
• Fantom Wolf
• Sandbox

Similarly, other DeFi protocols are adopting this approach to gamify DeFi. A great example of this is DeFi land. In this agricultural simulation - each cryptocurrency is represented in the form of a plant. Solana is a sunflower, USDC is a corn plant and so on. Players can farm these tokens and earn an annual percentage yield. Of course, they could do this through more traditional DeFi protocols, but the interface and accessibility of DeFi games are ideal and far more appealing for novice DeFi investors.

The crypto play to earn DeFi model has also been tweaked into the play to watch DeFi model. A good example of this is Brave's BAT (Basic Attention Token). Brave is using BAT to pay users to watch ads.

Derivatives and Margin Trading

Decentralized exchanges have opened up a world of decentralized trading. You can find pretty much any kind of advanced trading opportunities you want from futures to options to futures to margin trading.

The risks and rewards here are big and they’re not for the faint of heart. While some experienced investors do well financially from advanced trading and make money, many do not.

How is DeFi Taxed?

With tax authorities around the world cracking down on crypto investors, it’s important you understand the tax implications of your DeFi investments.

We’ve barely even scratched the surface of the various capabilities and opportunities DeFi offers to investors and DeFi is constantly developing. What this means is tax offices haven’t yet issued exact guidance on DeFi taxes.

However, all tax offices have clear guidance on crypto taxation and it always falls under two different types of tax - Income Tax or Capital Gains Tax. This is dependent on whether your crypto investment is seen as regular income or whether it’s seen as a disposal of an asset. Let’s break it down.

Income or capital gain

Your crypto investment - DeFi or otherwise - is always going to be seen one of two ways from a tax perspective. 

1. It’s seen as you making money, like any other form of income. Examples of crypto seen as income include being paid in a salary, mining and staking. This would make it subject to Income Tax.
2. It’s seen as you disposing a capital asset - like a share or a rental property. Examples of a disposal of crypto include selling your crypto for fiat currency, swapping it for another cryptocurrency, spending it on goods or services or even gifting it in some countries. This would make it subject to Capital Gains Tax.

What this means is though the IRS, HMRC, ATO and other tax authorities haven’t given clear guidance on DeFi tax yet, existing guidance already lets us see how many other types of transactions are taxed. 

Though DeFi is relatively new - the individual transactions that DeFi investments are made up of already have clear tax implications. We just need to look at each DeFi transaction and infer whether it will be seen as a kind of income or a capital gain, then apply the right tax accordingly. We’ll break down each type of transaction available in DeFi and how it would be taxed in most countries.

Although this is just guidance to help you with your DeFi taxes, remember the more aggressive a tax position you take, the greater risk you have of being reported and audited. This is why we use a conservative tax strategy to decrease risk.

It’s also important to note this is not country specific guidance. Some countries vary in the way they see crypto transactions. You should always check your country’s crypto tax rules.

DeFi Tax: Loaning Crypto

From a tax perspective, when you loan crypto using DeFi platforms, this could be seen as a kind of disposal and subject to Capital Gains Tax - even though you’re not getting rid of the asset. 

This is because when you loan crypto, many DeFi protocols exchange your loaned currency for a new crypto token. Crypto to crypto trades are seen as a disposal in most countries and subject to Capital Gains Tax. 

Of course, if you do not receive a token in return for your asset, this would not be the case. In these instances, you're not disposing of your crypto - you're merely moving them to a specific vault or pool. This could be viewed as more similar to a transfer which is not subject to tax.

DeFi Tax: Borrowing Crypto

When you borrow cryptocurrency, you aren’t earning income and nor are you disposing of an asset. This would not be subject to Income Tax or Capital Gains Tax.

DeFi Tax: Liquidity Mining

The tax you pay on liquidity mining will depend on the specific protocol you're using and how it rewards you.

Some protocols reward you with one token in exchange for your asset. You don't earn multiple tokens the longer you leave your asset in the pool. Instead, the value of your token increases the more active the pool is. In this instance, you're not actually earning new cryptocurrency. You'll only realize a gain or profit when you later sell your token. If your liquidity mining is similar to this, this would likely be viewed as a capital gain and subject to Capital Gains Tax.

On the other end of the spectrum - some DeFi protocols will reward you with multiple tokens for providing liquidity. In other words, you're receiving new crypto in exchange for a service you're providing. Because you're 'earning' new tokens, it's more likely this would be viewed as income and subject to Income Tax.

Almost DeFi protocols work in one of the two ways above, so the tax you pay will depend on which yours is similar to. Put simply:

Income Tax: if you’re ‘earning’ new coins or tokens through liquidity mining.

Capital Gains Tax: if your balance of tokens stays constant, but increases in value.

DeFi Tax: Adding Liquidity

When you’re adding capital to liquidity pools, you’re not disposing of your asset. You’re moving your funds to another place, much like a transfer which is not seen as a taxable event. There is no disposal, you are not making any additional income and therefore it is not subject to Income or Capital Gains Tax.

However, if you receive a token in exchange for your added liquidity - this could be seen as swapping one crypto for another. This could make it subject to Capital Gains Tax.

DeFi Tax: Removing Liquidity

When you take back your original capital from a liquidity pool, you’re not receiving any new funds and you’re not disposing of any of your cryptocurrency. This means it would not be subject to Income or Capital Gains Tax.

Like above, if you've received a token in exchange for your capital and you're swapping the token back for your asset - this could be viewed as swapping one crypto for another. Again, this could make it subject to Capital Gains Tax.

DeFi Tax: Staking

This one is fortunately very simple as many tax offices have already issued guidance on staking, so we can follow the same guidance for staking on DeFi protocols. The majority of tax authorities around the world view rewards from staking as a kind of additional income and therefore apply Income Tax.

DeFi Tax: Yield Farming

Yield farming isn't one specific type of transaction, but made up of many different transactions which will vary depending on the specific yield protocols or yield farming strategy you're using. You can use the other sections of this guide to identify the different individual transactions involved in your yield farming and how they would be taxed. But in summary - if you're seen to be earning new cryptocurrency, this is likely to be viewed as income and subject to Income Tax. Whereas if you're selling, spending or swapping cryptocurrencies - this is more likely to be viewed as a capital gain and subject to Capital Gains Tax.

DeFi Tax: Paying Interest

When you pay interest as a result of borrowing crypto, you’re not earning income or making any kind of disposal. This would not be subject to Income Tax or Capital Gains Tax.

However, if you're paying interest in crypto - like ETH - this could be seen as spending crypto on goods or services. This would make it subject to Capital Gains Tax.

DeFi Tax: Earning Interest

If you’re earning interest as a result of loaning your crypto assets, this could be seen as a kind of income. You’re receiving something in reward for a service, which the vast majority of countries view as income and would apply Income Tax. Like with liquidity mining above - because different DeFi protocols reward you differently, your transaction may be viewed as either income or a capital gain depending on how you're rewarded. Learn more about tax on crypto interest.

DeFi Tax: Play-to-Earn

There isn't any clear guidance on play-to-earn DeFi or gamified DeFi tax just yet. But that doesn't mean you won't pay tax on it.

When you're seen to be making an income, like earning new tokens from play-to-earn games, you'll most likely pay Income Tax. The amount you pay will be based on the fair market value of that token on the day you received it. Similarly, if you're earning tokens through the play-to-watch model, this could be viewed as income and subject to Income Tax.

When you later sell, swap, spend or gift these earned tokens, any profit from this will be subject to Capital Gains Tax.

DeFi Tax: Derivatives and Margin Trading

Trading itself doesn’t attract taxes since you’re not disposing of an asset. However, when you close on your position, you’ll have a realized profit or loss. In many countries, how this is taxed depends on the scale at which you’re trading.

For those seen to be trading as a business, these profits will be taxed as income. For those seen to be trading as an individual investor, you’ll only be taxed on your realized gains or losses under Capital Gains Tax.

While there is no specific guidance on crypto trading for many countries, there is extensive guidance on how traditional trading is treated from a tax perspective. Crypto investors should research their specific tax authority guidance on derivatives and margin trading or speak to an accountant.

Margin Calls and Liquidation

When you’re using DeFi platforms for margin trading or derivatives, if the value of your collateral falls too far, or if the value of the borrowed assets increases too much, this will liquidate your assets. Liquidation could be considered a disposal as you no longer hold your asset. This would make it subject to Capital Gains Tax.

DeFi Transaction Fees Tax

There is no specific guidance on the tax treatment of DeFi transaction fees or gas fees. However, transaction fees on disposals are tax deductible under Capital Gains Tax rules in most countries. Transfer fees are a little less clear - see this article.

DeFi Tax: Wrapping

Some DeFi protocols require you to ‘wrap’ coins before they can be deposited into a smart contract. For example, to use BTC within an ETH-based DeFi platform, you can ‘wrap’ BTC using Ren. This essentially holds your BTC in escrow and exchanges it for an ERC-20 token of the same value.

This could be seen as exchanging crypto for crypto, which is a disposal of assets. Even if you’re not making any realized gain or loss, you may still need to declare it. 

DeFi Tax: Token rebases

To maintain a consistent value for tokens, many DeFi protocols have a rebasing function. This function adjusts the total coin supply according to the price fluctuation. So if the value of a given token should be $1 and the price drops below that - the protocol knows to reduce the number of coins in circulation. Similarly, if the price climbed above $1, the protocol would increase the number of coins in circulation. For tokens like STETH - these token rebases occur on a daily basis to keep the price constant, so you may end up with more or less tokens as a result of this.

Of course, tax offices haven't issued specific guidance on token rebases. However, we can liken it to a stock split. A stock split happens when a company splits existing shares into further shares, increasing liquidity. Most tax offices - including the IRS - do not view this as a taxable event. Though the investor may have more shares - the shares have the same market value as the shares prior to the stock split. With this in mind, it would be reasonable to assume token rebases may be treated in a similar vein.

Curve Finance Taxes

We wrote about Curve about already, but to recap - Curve is a very popular DEX on the Ethereum network, specializing as a stablecoin exchange. Liquidity pools on Curve are also supplied to other lending protocols - like Compound - offering higher APYs for investors.

Liquidity providers are rewarded with transaction fees. The more transactions there are in a given liquidity pool - the more liquidity providers earn. These fees are rewarded as 3CRV tokens, which you can claim weekly. As you're earning new tokens - this would likely be seen as income and subject to Income Tax.

Some liquidity pools on Curve further incentivize users by rewarding them with different LP tokens - for example, LDO tokens. Like the above - because you're earning new tokens, this is likely to be viewed as income from a tax perspective and subject to Income Tax.

When you later sell, swap, spend or gift your CRV or other LP tokens - this will be subject to Capital Gains Tax.

If you're trading crypto on Curve - this will be taxed just like regular crypto transactions. Trading crypto for crypto is taxed as a capital gain in most countries.

Compound Finance Taxes

Compound is a leading DeFi lending protocol that lets users borrow and lend crypto - as well as earn interest for doing so.

tgWhen you invest in a given Compound liquidity pool, you'll receive a cToken in exchange. There are a variety of cTokens available representing different assets, for example, cEth, cDAI and cBAT. From a tax perspective - this could be seen as swapping one crypto for another and subject to Capital Gains Tax.

Unlike Curve, when you earn interest on Compound, you don't earn more cTokens. Instead the cToken(s) accumulate interest based on the value of the underlying asset and the exchange rate of that asset. In other words, each cToken becomes convertible into an increasing amount of the underlying asset - like ETH - but the number of cTokens in your wallet remains the same. As you're not earning new tokens, this is less likely to be seen as income. You'll only have a realized profit when you exchange your cToken back for the underlying asset. At this point - you'll realize a capital gain. You're swapping crypto for crypto and it is likely to be subject to Capital Gains Tax.

Everyone who uses the Compound protocol, whether to lend or borrow is rewarded with COMP governance tokens. COMP is distributed proportionally - so the more cTokens you have the more COMP you'll get. Because you're earning new COMP tokens, this is more likely to be viewed as income and subject to Income Tax. In addition to this, when you later sell or swap your COMP tokens, this would be subject to Capital Gains Tax.

Uniswap Taxes

Uniswap is a P2P DEX that lets investors trade ERC-20 tokens. In exchange for providing liquidity, investors get a pool token that represents their staked contribution in the pool. You can then later redeem this token for a share of the trading fees that UniSwap charges.

Like Compound - you're not earning new tokens so it's unlikely to be seen as income. Instead the value of your token has increased. When you initially provide liquidity, as you receive a token in exchange - this could be viewed as swapping crypto for another crypto and subject to Capital Gains Tax. When you then redeem your token for the underlying asset later, this would be subject to Capital Gains Tax.

Investors can also earn UNI tokens by staking tokens in certain liquidity pools. As you're earning new tokens when you earn UNI tokens - this could be viewed as income and subject to Income Tax. When you later dispose of your UNI tokens by selling, swapping or gifting them - this will be seen as a disposal and subject to Capital Gains Tax.

If you're trading crypto on Uniswap - this will be taxed just like regular crypto transactions. Trading crypto for crypto is taxed as a capital gain in most countries.

Calculate DeFi tax with Koinly

Koinly crypto tax software calculates all your crypto taxes for you, including DeFi taxes. All you need to do is sync the wallets and exchanges you use with Koinly through API or import a CSV file of your crypto transactions. From here, Koinly will identify your different crypto transactions and apply the relevant taxes. Your data should be labelled automatically, but if it isn’t you can tag your DeFi transactions as a loan interest, an interest payment, received from pool, sent to pool or a reward.

We give you complete control over how conservative you’d like to be with your crypto tax reporting. In our settings, you can choose whether to realize gains on liquidity transactions and whether to treat other gains as capital gains.