In this article, we take a closer look at some DeFi transactions and discuss how US tax principles might apply.

The explosive growth of Decentralized Finance (DeFi) has created a new ecological environment of investment opportunities limited only by developers' programming ability and economic creation ability.

While HM Revenue & Customs recently released guidance on DeFi transaction processing, the IRS has yet to issue any authoritative guidance on the matter. Understanding DeFi tax treatment in the US can be difficult. In this article, we take a closer look at some DeFi transactions and discuss how US tax principles might apply. Because some terms in DeFi are used in multiple ways, for clarity, we will detail the definitions of each activity.

US DeFi Taxation Overview

Like the UK, US income tax rules are based on the economic rather than structural characteristics of the transactional activity. Income from investments is generally taxed in two ways:

1. Ordinary tax rate;

2. Gains on capital assets, but only gains realized on the sale of the asset are considered taxable income.

Cryptocurrency is considered property in the United States, but unlike other specific types of property (such as securities or commodities), as of now, the United States has not established any targeted tax regulations or rules, such as the current implementation of securities or other traditional financial products. The "Wash Sale Rule" (Wash Sale Rule) or the securities lending tax exemption provisions of Section 1058 (US Code 1058) of the US Tax Code.

If part of the DeFi transaction is to obtain goods or services in exchange for cryptocurrencies or other digital assets, the IRS will treat it as ordinary income and tax it. On the other hand, if the property increases in value, the gain on subsequent sale or disposal is considered a capital gain and is taxable.

Cryptocurrency Swap

Swap refers to the activity of exchanging one cryptocurrency for another through a self-governing DeFi protocol. From a tax perspective, there is no difference to trading cryptocurrencies on a centralized exchange. A cryptocurrency swap is merely a disposition of assets that will result in capital gains or losses, and the value of the assets acquired will determine the proceeds received when selling cryptocurrencies and the cost basis (Cost Basis) of cryptocurrencies received.

Liquidity Mining

Yield Farming, sometimes called Liquidity Farming, is a common term in the DeFi space. It involves many different activities and projects, but generally it is to obtain some kind of return through the cryptocurrency held. In detail, miners provide cryptocurrency (liquidity) to the liquidity pool, and according to A proportion of the liquidity of that cryptocurrency in the pool is compensated with fees and tokens.

In the concept of liquidity mining, two basic activities are involved - lending and staking. Although these two terms are used to describe activity in the DeFi space, they do not always accurately reflect the economics of DeFi transactions.

Cryptocurrency Staking

Cryptocurrency staking is the process of temporarily depositing and locking cryptocurrency in a designated wallet to activate detection software and become a validator for a Proof of Stake (PoS) blockchain. In short, it is to obtain voting rights by staking cryptocurrency. After activation, the verifier will receive a new block from the peer node on the blockchain network, and the verifier can vote on whether to support the block (called certification), To ensure the security of all transactions. Corresponding cryptocurrency rewards will be obtained for redemption at maturity.

A staking pool is another staking mechanism whereby cryptocurrencies are deposited into a liquidity pool, but the term is more applicable to describe transaction validation on a PoS blockchain network.

Is providing cryptocurrency to the liquidity pool a loan

Placing cryptocurrencies into liquidity pools should not be considered traditional lending under U.S. tax principles, and may be considered a taxable disposition.

U.S. tax principles focus on the economic activities that occur during a transaction, not on the labeling of those activities. Some professionals will compare it to lending in liquidity pools in the DeFi space, but it is still different from typical property lending. Cryptocurrencies are property, not currency, so lending crypto is taxed differently than lending cash. When we lend cash, it is not considered a taxable event because cash is not property. Even lending out property, such as a car or a house, is not taxed because, strictly speaking, the so-called "loaning out" a car or house simply allows someone else to use the property for a period of time, and the borrower will return for compensation. While it's in their hands, they can't sell it or change it; they can only use it.

It can be seen from this that putting cryptocurrency into the liquidity pool is not the same thing as described above. When we put cryptocurrency into a liquidity pool, users who also provide liquidity to the pool are not just using the cryptocurrency in the pool, but get it and can exchange tokens with other users in the pool. Decentralized transactions between. Such operations mean that the investor has relinquished control of the cryptocurrency, agreeing only to redeem an equivalent amount of units or value at a future date. According to US tax principles, giving up ownership of the property, even if there is an agreement that the property will be reclaimed at a future date, the property still needs to be taxed. In short, putting cryptocurrency into a pool means relinquishing title to the units, in the same way as relinquishing title to property, will generally be considered a taxable event and will recognize whether those units generate capital against the cost basis of the asset gain or loss.

When an investor exits the pool, new units will be reacquired, and the liquidity value of the new units will be charged to the cost basis. Investments in liquidity pools may involve capital gains and losses if the value of the liquidity of the new units changes compared to the value initially invested.

**Why aren't liquidity pools tax-free like stock lending? **

When stock is lent for securities loans, the lender is deemed to have completely waived ownership of the stock, and the borrower generally acquires ownership and can dispose of it at will, including selling the stock, but according to Section 1058 of the U.S. Tax Code, Securities lending or transfers are tax-free, as are gains and losses on the securities involved in the transfer, but this tax break does not apply to cryptocurrencies. While liquidity pool transactions are similar in approach to securities lending, cryptocurrencies are not tax-exempt in this case.

This example shows that the tax exemption benefits of certain traditional financial products (such as securities) do not apply to cryptocurrencies. Conversely, there are certain rules that do not apply to cryptocurrencies. While cryptocurrencies are not subject to the rules, cryptocurrency traders can still benefit from this type of investment strategy known as "wash sales".

Tax rules for earnings in the liquidity pool

When holding liquidity in a liquidity pool, you usually get income from the pool. Many people view this gain as interest, but under U.S. tax law, the two should not be considered interest, despite their conceptual similarity. The distinction between the two is important; receiving or paying interest has special benefits under tax law, so mistaking income for interest can lead to incorrect tax filings. Under tax law and case law, interest is compensation paid using cash, not property. In the crypto ecosystem, earnings represent compensation for using cryptocurrency, not cash.

Gains are generally considered ordinary income. When the return is based on some kind of contractual right, it is considered income, in other words, because the liquidity pool is run through smart contracts, similar to physical contracts, these contracts stipulate the benefits that users who put into the pool will receive. As ordinary income, the fair market value of the proceeds received should be reported as income when received. The amount reported as income will also set the cost basis for the cryptocurrency received in the form of income. In the future, this cost basis will be used to determine whether a capital gain or loss has been incurred on the disposal of the asset.

**Can earnings be converted into capital appreciation? **

More recently, developers have started building DeFi products designed to convert earnings into capital appreciation. This is accomplished through some sort of protocol that translates generally per-unit growth yields into growth in the value of an investor's cryptocurrency (liquidity) in the pool.

The agreement will record the time when the cryptocurrency is put into the liquidity pool, and its income is not reflected by the increased cryptocurrency unit, but by the time growth of the original unit legal value. Therefore, when an investor exits the pool, the number of units does not change, but the value does; this change in value reflects the gain received by the investor, but for tax purposes it is treated as a capital gain rather than through Ordinary income achieved by additionally acquired units.

To facilitate this time-based value growth, protocols often require the additional step of wrapping the associated cryptocurrency into an enhanced version of the original cryptocurrency in order to achieve time-based value growth. It is unclear whether these tax-efficient products can withstand the scrutiny of the US Internal Revenue Service (IRS). After all, in Section 1258 of the tax code, there are special rules for traditional financial products that prohibit such conversion of income into ways to add value.

Whether DeFi transaction fees enjoy tax incentives or exemptions

When transferring cryptocurrencies between blockchains, entering or exiting a DeFi protocol, transaction fees will be incurred, and such fees are often referred to as miner fees or handling fees.

According to tax law, the treatment of these expenses basically falls into two groups:

1. Fees for direct acquisition or sale of cryptocurrencies

2. Fees charged for "transfers of cryptocurrencies between blockchains" and considered part of the investment activity

Tax Benefits

Expenses associated with directly acquiring or selling cryptocurrencies will be included in the cost basis for acquiring cryptocurrencies or used to offset gains from selling cryptocurrencies.

NO TAX BENEFITS

There are no tax benefits if the fees charged for the transfer of cryptocurrencies between blockchains are considered part of the investment activity.