What is decentralized finance (DeFi), and how is it taxed?
Decentralized finance (DeFi) is a rapidly growing segment of the crypto space that increases people's access to financial services. You can borrow, lend and trade at lightning speed and without the delays, fees, and bureaucracy of more traditional banks. DeFi is riddled with complexity and with complex tax implications.
The IRS hasn't caught up with these technological innovations to add salt to the wound.
So when it comes to DeFi taxation – its taxation solidly falls into the camp of we have no idea. There are no current IRS guidelines as to how we should be treating many DeFi transactions.
That being said, most of what's happening in the DeFi space right now is not without precedent. It looks pretty new; it looks pretty shiny. And it's a very new take on some old methodologies. But we believe here at Vincere Tax, that you can create coherent arguments about how some of this stuff might get taxed so that you can put in the best effort and stay on Uncle Sam's good side.
ETH > wETH
Please bear in mind that these are not recommendations. We do not have firm confirmation from the IRS on how this stuff is taxed. And we'll be using a case-by-case basis for our clients. So you take your ETH, and you want to participate in ERC-20 token, but it isn't the ERC-20 yet. So, what do you do? You wrap it into wETH. You use a wrapping function, take your ETH, it goes away, and now you have wETH on the blockchain. What happened here?
The argument, this is not a taxable event. This argument suggests it is effectively taking one type of asset and staking it. So you're taking your ETH, and you're putting it locked away in a contract and borrowing wETH against it at a one-to-one loan value. So, this is not actually trading your ETH for who you have not traded one coin for another. You have lent your ETH to a contract, and it has generated wETH for you as a loan. This means you still have underlying exposure to your ETH. You could get it back if you wanted, right? So you could reverse the transaction at a one-to-one ratio. So, you could take your wETH and get your ETH back; it would keep its same cost basis.
Earning Interest in a Yearn Vault
What about staking some of your assets on a, let's say, in a Yearn vault or on Celsius. You put your assets in a Yearn vault and earn interest on them. This transaction is going to be taxable. Putting it into the vault is, again, staking it. This is not a taxable event; you still have exposure to the underlying asset. It's still your ETH. But the interest you receive from the Yearn vault is a taxable event every time you get that interest. That's money you didn't have before and should be taxed as interest when you get your underlying ETH back.
You unstack your underlying ETH, and the change in price between when you staked it and now should not trigger a taxable event. This is again using something as collateral; you still own it the whole time.
Some other DeFi exposures one might have would be something like a HEX contract where you lock your HEX up, accrue interest over time, get your hex back, and then get the interest bonus. Again, an interest bonus is taxable, but the underlying asset is still yours. You're exposed to it the whole time, and it does not cause a sale when it happens.
If you use a 1inch Exchange or one of the more complicated exchanges, that kind of farms out what happens with your coins when you move from one coin to another. That is still absolutely a taxable event. You have traded one coin for another coin.
There are many, many other DeFi transactions that we can go through in detail if you have them in your portfolio. We will be doing a case-by-case basis here because we don't have a direct ruling from the IRS. I hope this is helpful.