What is Liquidity Mining and How is it Taxed?
Liquidity mining is one of the new phenomena to spring out of DeFi platforms - empowering crypto investors to earn passive income on their assets. Learn what it is and how it’s taxed.
The phrase ‘liquidity mining’ first sprang up in around 2020 as DeFi gained traction. Since then DeFi has grown into a billion-dollar industry with thousands of investors looking for liquidity mining opportunities.
But there’s a lot of confusion around exactly what liquidity mining is. It’s often confused with yield farming - and rightfully so, as the two are closely related.
To further complicate things, there’s very little guidance available on how liquidity mining is taxed - if at all.
We’re covering everything you need to know about it in this guide.
Decentralized vs. centralized exchanges
Centralized exchanges use an order book to match seller and buyer prices, as well as process transactions. The term order book refers to an electronic list of buy and sell orders for a specific security or asset - like cryptocurrency, organized by price level.
For example, an investor wants to buy 1 BTC for $40,000 and another investor wants to sell 1 BTC for $40,000. Binance’s order book would match these two transactions and the price of 1 BTC is set at $40,000.
In this example, Binance is the centralized third party necessary to make these transactions work and they play an important role. Blockchains would struggle to process the order book in real-time - so transactions would be incredibly slow and cause issues for users.
Decentralized exchanges, or DEXs, sprung out of the Decentralized Finance (DeFi) movement. In brief, DeFi hopes to remove intermediary parties - like crypto exchanges - to give investors more control over their investments and finances.
Instead of using an order book, DEXs use liquidity pools and automated market makers (AMMs). For every single trading pair available on a DEX, there is a liquidity pool. The liquidity pool is made up of 50% of token A and 50% of token B.
When an investor using a DEX wants to exchange token A for token B, they put token A into the pool and take token B out. This allows users to trade quickly, without needing to wait for someone else wanting to trade the same pair of tokens for the same price.
Simple enough - but where does liquidity mining fit in?
What is liquidity mining?
DEXs are dependent on investors filling those liquidity pools to function. Without them, investors can’t make transactions on their platform. The more liquidity the DEX has, the more investors can trade and the more popular the platform becomes.
When a trade happens, users will pay a transaction fee. The DEX distributes that transaction fee proportionally to liquidity providers anytime there is a transaction in their liquidity pool. This is a kind of yield farming - liquidity mining sprung up as a niche from this.
To attract more investors and more liquidity providers, some DEXs - like Compound - introduced their own token and used this to ‘pay’ their liquidity providers. While many of these tokens were originally created as governance tokens and held little monetary value, many of them like Uniswap’s UNI token quickly soared in value and became very desirable to investors.
Other DEXs quickly hopped on this trend and rewarding liquidity providers with tokens is now commonplace.
Now when you add your funds to a given DeFi liquidity pool - you’ll get a token (or tokens) in exchange that represents your fund in the pool. When you want to take your original capital back out of the pool, you’ll exchange your token(s) back for the equivalent amount that you put in and your tokens will be burned.
This means there are lots of opportunities for liquidity mining available. It’s a means for investors to make passive income from their investments and the rewards when the value of a given token soars can be huge.
How is liquidity mining taxed?
Now you understand liquidity mining, we can look at the tax implications of it.
Because liquidity mining is such a recent phenomenon, most tax offices worldwide haven’t yet released guidance on it. But this doesn’t mean you aren’t liable to pay any taxes on it, it just means investors need to interpret the current crypto rules and apply them to liquidity mining 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.
So while there’s no clear guidance on liquidity mining specifically, there is plenty of guidance on transactions similar to these from various tax offices around the world. How liquidity mining is taxed will be dependent on where you live and whether your tax office views the transaction as a capital gain or as income. Let’s break it down.
Capital gain vs. income
Your crypto investments will only ever be viewed in one of two ways - as a capital gain or as income.
Income: you’re earning crypto - like any other form of income and it is subject to Income Tax. Examples of crypto income could be mining, staking, or being paid in crypto.
Capital gain: you hold crypto assets as an investment and when you sell them - you make a capital gain or loss. Selling isn’t the only time you’ll make a capital gain or loss, you’ll also make one when you swap your crypto for crypto, spend your crypto on goods or services, or even gift your crypto in most countries. These are what’s known as a ‘disposal’ of an asset from a tax perspective. Any profits made from a disposal are subject to Capital Gains Tax.
With this understanding - let’s look at what the three transactions we outlined above would be seen as.
Tax on adding funds to a liquidity pool
You’re not earning crypto by sending funds to a liquidity pool so it isn’t going to be subject to Income Tax.
It’s a little foggier when it comes to Capital Gains Tax. Some will argue that this could be seen as similar to a transfer (moving your crypto from one place to another), which is tax free.
This said, on some DeFi platforms - like Compound - when you send funds to a liquidity pool, you’ll get a token in exchange to represent your investment in the pool. Swapping one token for another is a kind of disposal and would be subject to Capital Gains Tax.
Tax on removing funds from a liquidity pool
Like the above, we don’t need to worry about Income Tax when you remove any funds from a given liquidity pool. You’re not earning any new crypto - you’re simply taking back your original capital.
If we take the stance of likening this to a transfer, this is not a transaction that is considered a disposal. You’re making no capital gain on this transaction, you’re just moving funds around.
However, if you’re using a platform where you’re giving a token back in exchange for your funds, this would be a swap and any profits would be subject to Capital Gains Tax.
Being rewarded with a token
This is probably the most complicated transaction from a tax perspective. It could fall under Income Tax or Capital Gains Tax - or possibly even both if you later dispose of an earned token.
This is because different DeFi platforms 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 likely to be seen as a kind of disposal, as you're exchanging one crypto for another. This would make it subject to Capital Gains Tax, not income tax. Uniswap and Balancer pools work in a similar way to Compound.
But other DeFi platforms work differently. 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 is more likely to be seen as income.
All DeFi platforms will work in a similar way to the two examples above. So you’ll either pay:
Income tax: if you’re ‘earning’ new coins or tokens.
Capital Gains Tax: if your balance of tokens stays constant, but increases in value.
All this said, you’ll also need to consider the specific crypto tax rules for your country when figuring out which kind of tax applies to your liquidity mining transactions.
How is liquidity mining taxed in the US?
The IRS hasn't released specific guidance on liquidity mining tax yet. However, they have taken some pretty strong stances as to when crypto should be taxed as income. For example, the IRS taxes coins received as a result of an airdrop or fork as income.
This suggests they may take a similar stance with liquidity mining and may subject all rewards from liquidity mining to Income Tax as opposed to Capital Gains Tax. We recommend speaking to a tax professional to get advice on this.
If you’re reporting your liquidity mining as capital gains - you’ll need to report this on Form Schedule D and Form 8949.
If you’re reporting your liquidity mining as income - you’ll need to report this on Form Schedule 1.
US crypto investors need to file their tax returns by April 15th each year.
How is liquidity mining taxed in the UK?
HMRC has released clear guidance stating liquidity mining is subject to either Capital Gains Tax or Income Tax - depending on how the specific liquidity pool you use works. If you receive a liquidity pool token in return - these transactions are subject to Capital Gains Tax. If you receive new tokens or coins, this would be subject to Income Tax.
If you’re reporting your liquidity mining as capital gains - you’ll need to report this on the Capital Gains Summary alongside your Self Assessment Tax Return.
If you’re reporting your liquidity mining as income - you’ll need to report this on your Self Assessment Tax Return.
UK crypto investors need to file their taxes by the 31st of January.
How is liquidity mining taxed in Australia?
The ATO has no specific guidance on liquidity mining tax yet, so it is advisable to speak to a tax advisor before reporting liquidity mining to the ATO. However, all your crypto transactions will either be viewed as a capital gain or income.
If you’re reporting your liquidity mining as capital gains - you’ll need to report this in the Tax Return for Individuals Supplementary Section.
If you’re reporting your liquidity mining as income - you’ll need to report this on the Tax Return for Individuals form.
Australian crypto investors need to file their tax returns by the 31st of October (or the 15th of May if you’re using an accountant).
How is liquidity mining taxed in Canada?
The CRA has no specific guidance on how liquidity mining would be taxed. However, the CRA is very clear that crypto is either subject to Income Tax or Capital Gains tax depending on whether your investments are seen as a business activity or as an individual investment.
The CRA decides this on a case-by-case basis, but they do clarify that if investors “show that they intend to make a profit” or “carry on activity for commercial reasons” this would be a sign that you’re conducting business activity. As the whole purpose of liquidity mining is to make a profit, it’s likely that they would view it as income and subject it to Income Tax.
You should speak to a tax advisor for guidance on this.
If you’re reporting your liquidity mining as capital gains - you’ll need to report this on the Schedule 3 Form.
If you’re reporting your liquidity mining as income - you’ll need to report this on the Income Tax Return T1.
Canadian crypto investors need to file their tax returns by the 30th April.
Calculate Liquidity Mining Taxes with Koinly
Koinly makes calculating your liquidity mining taxes easy. We support liquidity transactions carried out on the Ethereum, Binance Smart Chain, Polygon blockchain, and more. In most instances, liquidity transactions are imported and tagged automatically. But you can also add these tags to transactions manually.
We support a number of liquidity protocols such as:
By default, we treat liquidity transactions as taxable since you are exchanging your tokens for an LP token which itself can be traded or staked to earn more coins. However, if you feel that such liquidity transactions should not be taxed then you can turn off "realize gains on liquidity transactions" in your Koinly settings.
Koinly makes crypto tax easy. Get started for free today.
Liquidity mining is a way to earn passive income from your crypto investments.
When you loan your assets to a liquidity pool, you'll receive a reward.
This is most often in the form of a token.
Liquidity mining will be seen either as a capital gain or as income.
If it's seen as a capital gain, it will be subject to Capital Gains Tax.
If it's seen as income, it will be subject to Income Tax.