Crypto Tax Guide: NFTs and DeFi

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The cryptocurrency space has evolved rapidly over its short lifespan; in just a decade it’s gone from a twinkle in Satoshi Nakamoto‘s eye to a thriving ecosystem encompassing dapps, DeFi and NFTs.

With crypto developing at such a dizzying pace, it’s unsurprising that tax authorities around the world have struggled to keep up at times; and for taxpayers, there are questions around how the more recent crypto innovations should be treated for tax purposes.

Two innovations that have seen massive adoption in the last year are decentralized finance (DeFi) and non-fungible tokens (NFTs). DeFi encompasses an entire ecosystem of decentralized financial tools and applications, with bleeding-edge techniques including flash loans and yield farming. NFTs are cryptographically unique tokens linked to digital content, including art and music; some NFTs have sold for astronomical sums.

Fortunately, the broad strokes of how crypto is taxed in the U.S. are fairly straightforward. Crypto is treated as a property in the U.S., not as a currency—similar to a share or a rental property. Depending on how crypto is acquired or disposed of, it will be subject to Capital Gains Tax and Income Tax.

Here’s the basic principle. If you earn crypto, it’s subject to Income Tax. If you sell, swap, or spend crypto, it’s subject to Capital Gains Tax. Although much of the tax guidance on cryptocurrency trading and investing is applicable to activities in DeFi and NFTs, there are also some novel or nuanced cases.

Before you can get to grips with your DeFi and NFT taxes, you’ll need to get your crypto accounts in order. Using Koinly’s crypto tax software, you can rapidly generate crypto tax reports, importing data directly from the ledger and syncing your exchange history in a single click—saving valuable time you’ll need to address the key questions around your DeFi and NFT activities.

Swapping on DeFi

Decentralized exchanges like Uniswap allow you to “swap” tokens—a practice that’s indistinguishable from selling and buying cryptocurrencies on centralized exchanges like Coinbase. So the same rules apply there: you pay capital gains on the proceeds, and the losses count as capital loss against your overall tax burden.

Borrowing on DeFi

Just like in traditional finance, there’s no tax on borrowed crypto capital. 

That means you can collateralize your crypto assets like Ethereum on lending platforms and take out tax-free funds. And you can use that capital to do whatever you want, of course.

Lending tokens on DeFi

Lending itself is tax-free, But what you get from lending is subject to tax, and it varies.

If you loan crypto to a lending protocol like Aave, you’ll receive aTokens in return–as a form of interest payment. aTokens will be subject to Income Tax, just like tax on regular interest earnings from lending in traditional finance. This is because they’re additional tokens that you receive into your wallet.

But some DeFi protocols don’t issue individual tokens. Instead, they issue yield-bearing tokens. Investors of protocol-owned liquidity protocol OlympusDAO hold swOHM, which remains constant in quantity but expands in value over time. Tokens like these are subject to Capital Gains Tax.

Staking tokens on DeFi

Staking involves pledging crypto assets to the network to help the blockchain validate transactions. Proof-of-stake networks like Ethereum 2.0, Polkadot, and Cardano will reward you with crypto for staking your coins—you get ETH for locking up your ETH.

Staking’s one of the ambiguous areas of the U.S. crypto tax practice.

The tax treatment of staking has been viewed as similar to earning interest–therefore Income Tax. But there’s an ongoing court battle involving a Tezos-staking couple who argue that staking is similar to manufacturing and should be subject to Capital Gains Tax on disposal. How you decide to report it is up to you and your tax accountant.

Paying interest on DeFi

Interest payments in crypto are subject to Capital Gains Tax, which means they would count as investment expense and therefore tax deductible. This is assuming you borrowed in the usual way with no further complications that would change the status.

Earning tokens on DeFi 

There are many ways to earn tokens on DeFi. These include:

👨‍🌾 Yield farming
💵 Crypto dividends
⚖️ Governance tokens
🎮 Play-to-earn tokens

Earnings from these activities are subject to Income Tax. But remember: it’s the earning part that impacts the tax status–not the acquisition of assets associated with these activities. You can buy Compound’s governance token COMP on the market and trade it, which is subject to Capital Gains Tax. But if you earn COMP as a result of your liquidity provision in Compound’s vaults, then your COMP gains will be subject to Income Tax. 

DeFi liquidity pools

Liquidity pools are smart contracts into which crypto assets are locked up to provide funds for DeFi activities like lending, borrowing, and swapping. Investors provide liquidity to receive rewards, such as shares of fees collected by a liquidity pool as people use them.

DeFi protocols will typically issue LP tokens that represent your share of the pool. When you decide to exit the pool, you can redeem LP tokens to receive your rewards–or losses as liquidity pools are prone to impermanent loss.

Tax treatment of liquidity pools is unclear given the complexity of the structure–there’s no equivalence in traditional finance after all.

One common tax approach is to treat liquidity pool activities as crypto-to-crypto trade, so the change in your liquidity position from entry to exit will be subject to Capital Gains Tax.

Buying NFTs

In principle, you don’t pay tax to buy NFTs, just as you don’t pay tax on buying fungible tokens like Shiba Inu (SHIB). But how you buy them matters greatly.

If you buy NFTs with Ethereum, as is the standard on NFT marketplaces like OpenSea, then you’ll have to pay Capital Gains tax on ETH you’ve disposed of.

There’s no tax if your purchase is made with fiat currencies like USD.

Trading NFTs

“Flipping JPEGs,” as NFT traders call it, can be a lucrative activity. But selling NFTs for a profit, often on secondary marketplaces like OpenSea, is subject to Capital Gains Tax, regardless of the asset or currency you receive in return: ETH, USDC or even fiat currencies.

Recall the principle: crypto-to-crypto trade (for example, selling ETH for WBTC) is typically taxed. Fiat conversion isn’t necessary to trigger a taxable event. So NFTs are no exception in this respect.

Minting/creating your own NFT: 

Minting as a term may seem confusing because it’s used in two senses in crypto. It refers both to generating tokens and also to being the first buyer of a token. For tax purposes, the latter is the same as buying, as explained above.

Minting in the first sense—creating an NFT—is tax-free. It’s just entering a data entry into the public ledger known as blockchain, and so there’s no taxable event. But minting costs gas fees, and so you may want to add expenses to your cost basis.

Selling an NFT you created

Some people mint NFTs just for the sake of it–or to turn their photos into hexagon profile pictures on Twitter. But for many others, minting an NFT is the first step to selling.

Selling an NFTs you created is subject to Income Tax. This is different from selling NFTs created by others on secondary markets, which is subject to Capital Gains Tax.

While it may be clear what you need to do in order to file your DeFi and NFT taxes, with so many moving parts and nuances to bear in mind, the practicalities of doing so can be complex. One solution is to use crypto tax software such as Koinly to streamline the process; by automatically importing details of your NFT trades, as well as your transactions on DEXs such as Uniswap and PancakeSwap, you can generate a comprehensive tax report in seconds.

For more guidance on how to file your crypto taxes, check out Koinly’s comprehensive tax guide.

Sponsored post by Koinly

This sponsored article was created by Decrypt Studio. Learn More about partnering with Decrypt Studio.

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