The crypto boom is attracting more and more people to invest paper into digital money. But how many are aware of their tax duties? Cryptocurrencies are treated as property for tax purposes in many countries.
DeFi and taxes
Capital gains and losses need to be reported on your taxes whether you sell, exchange, or otherwise use your cryptocurrency. No matter how you earn your cryptocurrency, either mining, staking, or forms of interest this income needs to be reported on your taxes.
DeFi is an abbreviation of the phrase “decentralized finance” which generally refers to the digital assets and financial smart contracts, protocols, and decentralized applications (DApps) built on Ethereum.
Simpler, it’s a concept where financial products are available on a public decentralized blockchain network making them open to anyone to use instead of going through a bank.
Any kind of lending activity makes you liable to pay taxes on any income you receive as a result. The income that you receive as a result of your lending activity can take one of two forms, ordinary income (like income received from a salary) or capital gains income.
How are they different?
Ordinary income is just taxed at your marginal tax bracket and carries no significant tax savings opportunities. However, when talking about capital gains income, the first thing to keep in mind is that it offers you long-term capital gains tax rates assuming that you held your asset for longer than 12 months.
You can actually save a lot of money considering long-term capital gains tax rates are significantly less than short-term capital gains rates. And one more thing capital losses cannot fully offset ordinary income (they can only offset up to $3,000 of ordinary income), whereas capital gains income can be completely offset by capital losses.
Generally, lending platforms will pay out interest in the same currency you lent them, and the interest that you are earning qualifies as ordinary income.
Liquidity Pool Tokens (LPTs) are issued by many new DeFi protocols when you lend them your crypto. Adding your tokens to a liquidity pool and receiving LPTs is considered a trade/token swap and that is why you may recognize capital gains income, not ordinary income. However, instead of being paid out the interest directly, the value of your LPTs increases.
“DeFi facilitates more complex transactions that weren’t previously possible on centralized exchanges. You can now trade any asset pair which makes it difficult to value transactions in your local currency for tax purposes,” says Shane Brunette, CEO of the easy-to-use platform CryptoTaxCalculator.
Brunette and his team designed a tool to accommodate the vast complexity underpinning cryptocurrency tax calculations at a global level. In the age of DeFi, platforms such CryptoTaxCalculator are helpful as many tax jurisdictions require you to keep detailed records of every transaction with the value marked in the local fiat currency.
“There are now interest-earning protocols that can attract income tax rather than traditional capital gains tax. Furthermore, everyone’s transaction data is openly and permanently exposed on the blockchain, making it easily auditable by tax agencies.”
Emerging need to get educated about crypto taxes as DeFi takes off
Remember the Golden Rule! Whoever has the gold, makes the rules! Or perhaps the bitcoins?
According to Bloomberg, the global leader in business and financial data and news, the April edition of “Crypto Outlook” predicts that bitcoin will reach a price of $400,000 by the end of 2021.
Such a pompous claim has been backed up by the analysts who have come to this figure through a series of calculations on bitcoin’s history, tracking its overall tendency for value to increase next to other factors like liquidity, volatility, and more.
The COVID-19 pandemic is expected to plunge most countries into recession, with per capita income contracting in the largest fraction of countries globally since 1870.
“Money managers reluctant to cross the Rubicon and allocate at least a small portion of funds may be at risk as Bitcoin simply does more of the same, advancing in price amid unprecedented low interest rates and elevated equities,” it is said in the report.
The bitcoin spike despite the floundering economy makes it the safest place for larger institutional investors to park their money. Bloomberg is claiming that even in the race between bitcoin and gold, bitcoin wins.
These are all speculations but it’s evident bitcoin has come up trumps in a time everyone expected the smallest inconvenience to bring it tumbling down. As Bitcoin and cryptocurrency adoptions grow, as well as the emergence of the DeFi business sector, so does the importance of taxation of digital assets.