Are DeFi Investments Exempted from Taxes?
There has been a widespread of cryptocurrency across different countries in recent times with the goal of creating a decentralised form of finance for individuals. While this development is relatively new, it keeps evolving, and one of the many forms is DeFi – Decentralised Finance.
DeFi has grown massively to more than a $40 billion ecosystem, and it keeps growing in value and popularity. However, with this intersection with finance, it is often a common cause of concern whether investments off DeFi is taxable or not?
Are you confused if your DeFi investments are exempted from taxes or not? Let us break it down to you in this post.
What is DeFi?
DeFi is short for decentralised finance, and just like other aspects of cryptocurrency, it is hosted on blockchain technology. DeFi allows ease and access to financial services, including lending, trading, and borrowing. The competitive edge of this form of finance over traditional institutions (e.g., banks) is the reduction of delays and additional costs incurred over financial transactions.
This form of decentralised finance is projected to transform or disrupt conventional financial institutions, and it has gained prominence among many users. DeFi is technologically enabled and can allow anyone anywhere in the world access to financial services without the involvement of a third party.
There are thousands of DeFi exchange platforms today, and most of them are built on the Ethereum blockchain technology. So, how does it work?
How does DeFi work?
DeFi executes the primary functions of banks as other financial institutions with even more features. First, users can take advantage of the decentralised exchange platforms to trade cryptocurrencies globally with less hassle. Users can use the DeFi system as a lending platform; this means you can lend out crypto with interest or gain profit through yield farming.
Also, you can lend out your cryptocurrency if you own an asset. For DeFi, you can lend your cryptocurrency to a protocol like Aave and Compound in exchange for interest. Similarly, you can also borrow from this protocol, especially when you need to facilitate a trade. In addition, you can also lock up your money in different assets to realise a profit, commonly called yield farming.
Yield farming and lending are oftentimes the commonly used applications on DeFi since they are utilised in earning assets. This simply means you can make money or profit from DeFi.
Now, to the big question…
Is DeFi investment exempted from tax?
When it comes to taxes, the rule for most countries is usually well spelt, and you do not want to be caught on the off-side of such a rule. But, when it comes to cryptocurrency, especially DeFi, which is more recent, it might get a bit unclear what is taxable or how much in tax you must pay by law.
Crypto taxing is still a topic of discussion as the ecosystem is constantly evolving. For instance, the Australian Taxation Office (ATO) has not released official guidance about how taxation works for decentralised finance, and this is a similar situation for other countries. However, there are some guidelines for tax implications for general cryptocurrency, and they are similar to DeFi activities.
The Australian documentation on taxation for cryptocurrency holds that cryptocurrency should not be considered a personal use asset if used for a profit-making scheme. Technically, this implies that profit, gains or wrapped assets on DeFi platforms are assessable income. To avoid throwing a blanket answer on this not-so-clear-area of cryptocurrency, it is best to consider it case-by-case.
DeFi ordinary income
Another way to examine the tax implication of DeFi investment is to look through the lens of what is generally classified as tax in regular traditional financial transactions. Ordinary income in the traditional financial setting is likened to salary. This implies that a marginal tax bracket is given to each individual's income.
For DeFi, lending out your digital assets can fetch you income. Lending platforms pay interest to you in the same currency you lent them. This is similar to interest that is incurred in traditional banks. The money realised from the interest gotten from lending out assets increases the value of your wallet. This form of money (interest income) is regarded as ordinary income.
Ordinary income is assessable and not exempted in almost all countries. This can be equally applied for DeFi investment, and taxes can be paid on such income. Although, ordinary income does not provide considerable tax advantages.
DeFi Capital Gains Income
The advantage of capital gain income over ordinary income is the tax savings. Capital gains income is qualified for long-term capital gains tax rates. This form of tax rate is usually lesser and can save a lot of money. To qualify for a tax savings opportunity on long term capital gain, you will need to hold your asset for more than 12 months.
Another advantage of the capital gains income is that it allows you to offset losses made on your capital over time. This advantage lets you pay less for losses made, and it has a significant value than ordinary income.
Most DeFi protocols (like Aave, Compound etc.) give out Liquidity Pool Tokens (LPTs) to users who lend their crypto to them. The LPTs do not pay you direct income; instead, they give you a portion of the liquidity pool. The pool gathers interest that increases over time, although the LPTs amount stays constant. A capital gain is realised when the LPTs are swapped back for assets.
This form of DeFi investment is accessible because it is seen as income gain, although it carries the long-term capital gains tax rate, making it more efficient.
Borrowing from DeFi
Just the same way you can lend out money on DeFi platforms, you can also borrow and, in most cases, trade or buy a digital asset. Is there tax implication for a borrower as well? Taking a loan on DeFi using cryptocurrency as collateral does not bring any financial gain for the borrower; therefore, it does not have a tax implication.
If any interest is paid on loan, it is interest for the lender who bears the tax implication of capital gains but not the borrower.
Taxing is not a rigid game
Taxing is not a rigid game because, as earlier stated, almost all countries have not released a specific guideline for how tax works for DeFi investment. Therefore, a significant part of the analysis is based on general cryptocurrency tax guidelines released by different countries and comparing the traditional financial institution policies.
However, it works differently from one country or region. While some countries/regions have strict policies about their taxing, others have a more flexible approach, especially regarding the evolving field of cryptocurrency.
Belarus is one of the friendliest cryptocurrency countries in the world. In March 2018, Belarus passed a law legalising cryptocurrency activity. Further, it exempted businesses and individuals from paying tax on gains made from cryptocurrency until 2023, when the law will be reviewed. Germany has a similar policy that exempts taxes on cryptocurrencies held by individuals for more than one year.
It is essential to stick to the laws of each country regarding cryptocurrencies, and all of their forms, especially for DeFi investments. These laws are also different for foreigners trading in the country or making an investment out of the country.
What about if you are required to pay tax in your country?
How to File Tax Returns on DeFi Investments
If you must file tax returns on your DeFi investments, it might be disturbing and challenging for you to follow through with the trades and exchanges made on the platform. Instead, you can manually lodge your taxes by tracking the market value for each crypto asset for the time of purchase and when the sales of the asset are made.
Alternatively,you can make use of crypto tax software. The software aggregates your transaction history from different exchange platforms and automates them to calculate your tax payable amount. This offers a quicker and more accurate way of calculating your tax payment for your crypto trades.
The reports generated from the crypto tax software can also be sent over to your accountant, who helps you generate your taxable position and lodge the tax returns. There are advantages of using an accountant as it offers you a favourable taxable position, and, in most countries, accountants are given an extended period to turn in tax returns.
Conclusion
If you are a DeFi investor, you need to understand the law of your country about cryptocurrency and how it is regulated. The cryptocurrency ecosystem is not entirely understood yet, especially for taxation offices and the government. You do not want to be caught on the offensive side of the law when it comes to paying taxes.
A rule of thumb is that any transaction that involves interest or capital gain will often be taxable except the law of your country states otherwise. And if you are required to pay tax for your investment on DeFi, think about filing your tax application either manually or by using crypto tax software.
You need further guidance on DeFi investments and taxation, and you want to remain on the right side of the law,check in with us today to help you remain financially safe.
