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TLDR

  • Decentralized Finance (DeFi) is a new financial infrastructure that uses blockchain technology to create decentralized financial applications.

  • DeFi differs from centralized finance, where middlemen like banks and financial institutions run financial markets.

  • DeFi transactions often involve cryptocurrency and are taxable in most countries.

  • The tax implications of DeFi transactions can be complex and challenging, as individuals face difficulties obtaining data, tracking cost basis, and dealing with the lack of standardization across different platforms and networks.

  • It is important to consult a tax professional for advice on how DeFi transactions will be taxed.

Introduction

Decentralized Finance (DeFi) refers to the use of blockchain technology to create decentralized financial applications that operate on a peer-to-peer (P2P) basis. This is in contrast to Centralized Finance (CeFi) which refers to traditional financial markets that operate through middlemen (e.g. banks, financial institutions, etc.). DeFi is a new type of financial infrastructure that allows new financial markets to be used by anyone, anywhere, and at any time.

Here are the main differences between DeFi and CeFi:

DeFiCeFi
Decentralized: DeFi applications are built on blockchain technology, which is decentralized, meaning that there is no central authority controlling the system. Instead, it is governed by a network of users and nodes.Centralized: CeFi systems are centralized, meaning there is a central authority controlling the system, usually the company providing the service.
Borderless: DeFi is available to anyone with an internet connection, regardless of location, making it more inclusive than traditional finance.Location dependent: CeFi is location-dependent, meaning in order to use their services, you need to live in a specific place or, in some cases, prove your citizenship.
Open-source: DeFi applications are often open-source, meaning that the code is publicly available for anyone to view and contribute. This also enables developers to fork and build off existing applications.Intellectual property: CeFi entities keep intellectual property legally protected so that outsiders can not use it.
Trustless: DeFi applications are trustless, meaning users do not need to trust a third party like a broker to use the service. This also makes them permissionless, meaning anyone can use the service without needing to be approved by a central authority. Decentralized networks use smart contracts to automate and secure transactions.Requires trust of a third party: CeFi entities need users to trust the company or individual providing the service. For example, banks, credit unions, stockbrokers etc.

How is DeFi different than Crypto?

DeFi involves cryptocurrency transactions (crypto); however, there are many ways to buy and sell crypto without participating in DeFi. Cryptocurrency can be bought and sold through several centralized exchanges like Coinbase, Crypto.com or even traditional banking apps. These online platforms are the most common places for people to manage their digital investments, and they follow a conventional bank-like structure. The key difference is that these applications act as a middleman, storing cryptocurrencies for their users and completing transactions for them. They are custodial, meaning they hold the private key to a user’s funds.

DeFi, however, refers exclusively to activities on decentralized exchanges explained above. While users still buy, sell, and transact in other ways with cryptocurrency, they have complete ownership of their assets in a Web3 wallet. Their transactions are peer-to-peer (P2P), which means they are decentralized instead of completed by a third party. A Web3 wallet is like a digital safe. Only its owner has the combination. In this way, they are non-custodial, allowing the user to manage their digital assets and interact with DeFi applications. Learn more about Web3 wallets here.

Types of Taxable DeFi Transactions

Here is a general overview of some common types of DeFi transactions and how they may be taxed:

  1. Lending: When an individual lends their crypto to another person or entity, they may be required to pay taxes on the interest earned from the loan. This interest income would be reported as taxable income on their tax return.

  2. Borrowing: When an individual borrows crypto from another person or entity, they may be required to pay taxes on the interest paid on the loan. This interest expense can be used to offset any interest income earned from lending, which can reduce the overall tax liability.

  3. Yield Farming: Yield farming is the process of lending or borrowing crypto assets to earn a return on investment. The returns from yield farming, such as interest or appreciation, are considered taxable income and must be reported on the individual's tax return.

  4. Staking: Staking is the process of holding a certain amount of crypto assets in a specific wallet or platform to validate transactions on a blockchain network. The returns earned from staking, such as rewards or appreciation, are considered taxable income and must be reported on the individual's tax return.

  5. Swaps and trades: Swaps and trades of crypto assets are considered taxable events and must be reported on the individual's tax return. The capital gain or loss from the swap or trade must be calculated based on the fair market value of the assets at the time of the transaction.

DeFi Tax Complexities

While the tax implications of DeFi transactions depend on each country's specific laws and regulations, DeFi transactions are considered taxable events in most countries. The gains or losses from these transactions must be reported on tax returns.

However, there are some key differences of DeFi transactions that make them more complicated from a tax perspective.

  1. Complexity: DeFi transactions can be very complex, making it more challenging to report and pay taxes accurately.

  2. Lack of regulation: DeFi is a relatively new and rapidly evolving field, and many countries still need to implement specific regulations for DeFi taxes.

  3. High volatility: DeFi transactions and assets are often highly volatile, making it challenging to calculate gains and losses accurately for tax purposes

  4. Variety: DeFi includes a wide variety of transactions such as lending, borrowing, yield farming, staking, and more, so there is no one-size-fits-all solution for taxing these events.

Overall, these differences result in a more challenging process of actually getting the data needed to do DeFi taxes.

Data Challenges

Individuals and companies face several challenges when getting the data needed for their DeFi taxes. Primarily, these include:

  1. Lack of data: DeFi transactions can occur on multiple platforms and networks, making it difficult to get all the data needed to report taxes. Some platforms do not provide transaction data in a format easily importable into tax software, making it challenging to report taxes accurately.

  2. Complexity: DeFi transactions can involve multiple types of assets and platforms, making it difficult for individuals to understand how to report taxes correctly.

  3. Difficulty in tracking cost basis: The cost basis is the original value of an asset, which is used to calculate capital gains and losses. DeFi transactions can be complex and involve multiple types of assets and platforms, making it challenging to track cost basis.

  4. Lack of standardization: DeFi transactions can occur on multiple platforms and networks, each with unique data and transaction formats, making it difficult to standardize and automate the tax reporting process.

As data specialists at Covalent, the need for more standardization is the biggest challenge when providing structured data and helping clients with tax applications. We do not have a lack of data or complexity as a problem, but the different standards across protocols that we index means that clients still have to understand the details of these protocols in order to make meaningful use of the data we provide them.

Tips and Best Practices

In order to comply with DeFi tax regulations, it is important to keep accurate records of all transactions, including the date, amount, and type. People can check how their transaction records are being retrieved in any crypto software they use. Data tools like the Covalent API offer comprehensive transaction record coverage, which can be used on its own or to power applications that do DeFi tax reporting. Staying informed about the latest developments in DeFi and regulations will help ensure compliance. Consulting a tax professional for advice and understanding your country's tax laws is crucial, as well as keeping track of the cost basis for each asset. It's important to be prepared for potential tax audits and have all necessary documentation ready to support your tax return.

Future Developments for DeFi Tax Regulations

It is difficult to predict what future developments and changes in DeFi tax regulations will be, as they will depend on the specific laws and regulations in each country. However, increased regulatory oversight and greater clarity on tax laws are likely given the rising popularity of DeFi. Governments may want to step in to protect customers and ensure compliance and will need to help these users understand their tax obligations. With this could also come increased enforcement of DeFi tax regulations. These tax authorities are equally interested in blockchain data to detect and report fraud.

Additional Resources

For more information and guidance on DeFi taxes, refer to sources like tax authorities’ websites, tax professionals, or crypto tax software providers. Many tax authorities, such as the IRS in the US, have information and guidance on DeFi taxes available on their websites. Additionally, certified public accountants (CPAs) can provide specific advice on DeFi tax obligations. People may also use crypto tax software providers to correctly understand and report their taxes. However, they should exercise caution if they have many complex transactions that may require a specialist to go through.

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