Decentralized Finance (DeFi) and taxes – Borrowing & Lending (Part 1)

At CryptoTax, we closely follow the developments in the blockchain-based financial services, which are known as Decentralized Finance or DeFi. With the continuous adoption of DeFi, the tax implications are also becoming increasingly relevant. We will examine the DeFi ecosystem and the most important tax consequences in a series of articles.

What is Decentralized Finance (DeFi)?

Decentralized Finance (DeFi) has become one of the most prominent topics in the Blockchain community. DeFi could be regarded as a further development of Bitcoin’s original objective, namely the decentralization of the monetary system. DeFi pursues the goal of decentralizing traditional financial services. At the heart of the initiative is the opening of the financial system by developing an inclusive ecosystem based on blockchain technology. This will result in decentralized approaches in the following service segments:

  • Borrowing / Lending
  • Stablecoins
  • Decentralized exchanges
  • Derivatives, exotic markets and prediction markets
  • Insurance[1]

Borrowing & Lending as a DeFi Killer App?

Introduction to MakerDAO

Decentralized lending, i.e. automated, smart contract-based borrowing and lending is currently the most widely used DeFi application. The MakerDAO project plays a decisive role here. MakerDAO is an Ethereum-based protocol, which among other things offers the possibility of lending or borrowing a stablecoin DAI that is pegged to the US dollar. In the meantime, there are assets worth over 500 million deposited with MakerDAO as collateral. This represents more than 50 % of the value of all assets in the DeFi ecosystem.[2]

The special characteristic of MakerDAO is that no central issuer is required to provide the US dollars peg, as is the case with Tether (USDT). In MakerDAO it is ensured by a mechanism inherent to the protocol itself.

To understand the concept of MakerDAO and DAI, it is necessary to analyze how the system works.

In a first step, any participant in the Ethereum network can create the stable coin DAI by depositing a collateral, i.e. a security deposit, through interaction with a smart contract (the Maker Contract). Currently, the Maker Contract accepts Ether (ETH) and Basic Attention Token (BAT) as collateral.

This creates a collateralized debt position (CDP), which is like credit line secured by a collateral. In Maker all positions need to be overcollateralized and the minimum collateralization ratio is currently at 150%. Thus, with the collateral deposit worth 100 US dollars, a maximum of 66.66 DAI can be generated. If the USD price of the collateral declines and the collateralization ratio falls below the minimum, the network will force the liquidation of the position a liquidation penalty will be paid. Hence most positions will be opened and held well above the minimum collateralization ratio to reduce the risk of forced liquidation. The minimum collateralization ratio and some other parameters of the Maker contract can change over time by the voting of the MakerDAO (MKR) token holders withing its governance system.

Borrower can pay back any part or the full amount of the outstanding debt at any time. In order to release the collateral, the amount of DAI created must be repaid, plus an annual interest rate (stability fee), which is also set by the MKR governance mechanism. By adjusting stability fee, MakerDAO can react to a sustained price pressure on DAI and maintain its peg to USD.

An increase in the fee is expected to reduce the demand for DAI (loans) and thus increase the market price, as less DAI is created or more DAI is repaid and vice versa.

Since November 2019 MakerDAO has enabled lending based on the Savings Rate, i.e. an interest rate that DAI holders receive for holding their DAI in the Maker smart contract. This interest rate is financed from the stability fees paid and its level – just like the other instruments of price stability – can be adjusted by the voting of the MKR holders.

From an investor’s perspective, the DAI Savings Rate offers an interesting new way of generating passive income without having to expose oneself to the volatility of cryptocurrencies. Since DAI is a distinct coin, it can also be easily bought on an exchange. As long as the price peg to the US dollar is maintained, Maker offers a highly attractive decentralized investment alternative to traditional fixed or overnight money investments.

Further information on MakerDAO can be found in the MakerDAO Whitepaper.

Investment opportunities from lending based on Decentralized Finance

In addition to Maker, there are other decentralized possibilities to generate income from lending stable coins or other crypto assets. These include for example the Compound protocol and dYdX. The decentralized nature of these services is particularly characterized by the fact that they are non-custodial solutions, i.e. the user has full control over his assets at all times and usually interacts with an external wallet such as MetaMask or Ledger with the respective smart contract. Furthermore, such offers can be used without registration or other restrictions, as no central party can be placed under regulation. Of course, the legal framework of such projects is still unclear, especially with regard to the regulatory position of the project initiators and development teams. In any case, there is no central body which could be held accountable in case of malfunction, user error or external attack. The full confidence therefore lies in the smart contracts used.

The situation is different for centralized lending providers for the blockchain-based assets. These are mostly custodial solutions, i.e. the provider keeps the assets for its customers (#notyourkeysnotyourcoins) and the user must be confident that the platform does not commit fraud and is strongly secured against external attacks. In addition, regulatory requirements are generally comparable to those in the traditional financial world. In contrast to decentralized offerings, this allows the option of interacting directly with legal tender such as US Dollar.

An overview of the most important providers can be found at the end of this article.

Tax implications

From the tax perspective there are both new and familiar issues arising from the decentralized lending and borrowing.

Tax treatment of the borrowing of cryptocurrencies or other tokens

If cryptocurrencies or other tokens are borrowed, the question arises whether the provision of collateral, the inflow of the loan amount and the repayment of the loan can lead to tax implications.

Deposit of a collateral

Decentralized and centralized services have in common that, in order to take out a loan (e.g. in a stable coin or another cryptocurrency), a collateral deposit is required, which cannot be moved until the loan is repaid. Therefore, there is some concern whether the provision of the collateral and the associated limitation of the economic power of disposal is sufficient to assume a taxable sales transaction.

However, as the economic ownership of the collateral remains with the borrower at all times in the case of both decentralized and centralized providers, the mere deposit of the collateral does not represent a taxable event.

Payout and repayment of the loan

The payout of the loan as well as the repayment of the principal are not taxable, provided the repayment is the same amount in value and denomination.

However, if the loan gets liquidated, then it will be treated as sale and needs to be reported as a capital gain/loss.

Tax deduction of the loan interest payments

It depends on the purpose of the loan, if you can deduct the interest payments. In the case of a loan taken for commercial purposes by a business, it can be deducted as a business expense.

Borrower of a personal loan usually cannot deduct the interest payments from the taxes. However there might be a possibility to deduct them as investment interest expenses, if the loan is taken for investment purposes. Unfortunately, there is no clear guidance from the IRS on investment interest expenses for cryptocurrency based loans, hence you may review some general principles described in this TurboTax article.

Tax treatment of the lending of cryptocurrencies or other tokens

When lending cryptocurrencies or other blockchain-based tokens, questions arise regarding the tax treatment the income from interest, the lending transaction itself, and the impact on the holding period relevant for the short term and long term capital gains.

Taxation of the lending income

In general, all income or rewards received by a taxpayer generated from the lending of cryptocurrencies must be reported to the IRS. The taxpayer must also identify whether they are a hobby or (self-employed) business lender for tax reporting purposes.

In general, the IRS states a hobby activity is done mainly for recreation or pleasure. The IRS uses the following criteria to determine whether a taxpayer’s profitable activity is deemed a hobby or a trade or business. Please note one factor alone is decisive and all factors must be considered:

  • Whether you carry on the activity in a businesslike manner and maintain complete and accurate books and records.
  • Whether the time and effort you put into the activity indicate you intend to make it profitable.
  • Whether you depend on income from the activity for your livelihood.
  • Whether your losses are due to circumstances beyond your control (or are normal in the startup phase of your type of business).
  • Whether you change your methods of operation in an attempt to improve profitability.
  • Whether you or your advisors have the knowledge needed to carry on the activity as a successful business.
  • Whether you were successful in making a profit in similar activities in the past.
  • Whether the activity makes a profit in some years and how much profit it makes.
  • Whether you can expect to make a future profit from the appreciation of the assets used in the activity.

The cost basis for the cryptocurrency received as lending income is its fair market value. Any subsequent sales or exchanges of the cryptocurrencies earned from lending will be treated as capital gain or loss.

Hobby Lenders

If the taxpayer is a hobby lender, based on the criteria listed above, the income received by the taxpayer as it relates to lending will be treated as ordinary income. Any losses associated with lending cryptocurrencies in this situation (i.e. hobby losses), cannot be applied against the taxpayer’s ordinary income.

To report ordinary income from lending as a hobby, the taxpayer will report the amount received as other income (Line 21) on Schedule 1- Additional Income and Adjustments to Income. As of 2018 through 2025, a taxpayer can no longer deduct any miscellaneous expenses related to hobby lending.

CryptoTax automatically calculates the taxable income from hobby lending and generates all forms you need already populated with the calculated values. It also includes a list of the transactions as required by the form.

Business Lenders

If the taxpayer is deemed to be engaged in a trade or business for which cryptocurrency lending generates trade or business income as above, the taxpayer must report any income or rewards received as self-employment income. Expenses related to the lending business activity like office, operating and other expenses may be deducted for tax purposes. Business lenders are also subject to self-employment tax at a rate of 15.3%.

To report business income from lending, the taxpayer will report the amount received as self-employment income and any related lending business expenses on Schedule C. The self-employment income is then translated from Schedule C to Schedule 1 (Line 12). Additionally, the self-employment tax beared by the taxpayer will be calculated and reported on Schedule SE. The self-employment tax is then translated from Schedule SE to Form 1040 (Line 14).

It is important to note unlike hobby lending income, net losses generated from the business lending activity may be used to offset the taxpayer’s ordinary income.

CryptoTax also supports tax calculation and reporting for business lending. It provides all the above mentioned forms and populates them with the calculated values. It also includes a list of the transactions as required.

Special considerations for Compound and other services when lend cryptocurrencies are exchanged

Generally lending transactions, such es depositing, locking and withdrawing the lent amount are not considered as taxable activity. However in some cases cryptocurrencies can be exchanged to others in the course of interaction with smart contracts. For example, by supplying new ETH for lending at compound, you will actually exchange ETH for cETH, which is another ERC-20 token. That means you are effectively selling your ETH and realizing a short or long term capital gain. Conversely, when you want your lent cryptos back, you will need to exchange the cETH to ETH. This might not be beneficial from the tax perspective, as there are two tax events that need to be considered in the tax report, which may lead to taxable capital gains, without generating any liquidity for the taxpayer. Additionally, even as you get back the ETH you lent, your holding period starts from the beginning and you might lose the benefit of the long term holding of the ETH.

Finally, the interest earned in compound is reflected in the increasing amount of the underlying asset paid back. Hence the interest earned on compound is paid as a short term or long term capital gain and not as income tax.

How to report taxes on DeFi lending using CryptoTax

1. Import data into CryptoTax

Decentralized platforms

For the decentralized  platforms you can just enter the ETH wallet address to get all the transactions for this wallet. This will usually include at least one withdrawal (which is a deposit to Defi account for saving) and one deposit (which is a withdrawal from the Defi saving account).

Now, you need to add the transactions of the Defi account itself. As most of the platforms do not provide a proper export yet, you will need to do it manually. In CryptoTax you can either add a single transaction in the UI or make a bulk import using our XLS/CSV template.

Please also make sure that you have separate transactions for the interest income and the repayment of the principal. We also recommend to mark the interest income as “Lending” directly in the template, as it will save you a lot of time and make sure the tax is properly calculated.

Centralized platforms

Centralized platforms like Nexo usually provide a possibility to export file that contains all transactions including the interest income. You just need to transfer the export file in CryptoTax according to our XLS/CSV template and import it. We also recommend to mark the interest income as “Lending” directly in the template, as it will save you a lot of time and make sure the tax is properly calculated.

2. Automatically link account transfers

You need to link transfers between the accounts to maintain the original acquisition data and make sure you benefit from the better rates on long term capital gains.

If you have properly imported your full transactions history, than CryptoTax app can do it for you automatically as described here.

3. Generate the report

With CryptoTax you get the most extensive report to make your tax reporting easy and fully compliant. We even include all the forms that you need already populated with the calculated values.

Now you can finish your crypto taxes and do something more fun!

 

Overview of the DeFi lending platforms and services

Non-Custodial

MakerDAO is currently the leading DeFi protocol. Currently you can deposit ETH or BAT as collateral and get the stablecoin DAI for it. However, you can also lend DAI and receive interest.

MakerDAO (Lending) via Oasis.app

MakerDAO (Borrowing) via Oasis.app

Compound is another DeFI protocol that can be used to lend and borrow Ethereum-based cryptocurrencies. Currently supported are DAI, BAT, ETH, Augur, USD Coin, Wrapped BTC and 0x. In the course of collateralization, lending involves the exchange of “compound” tokens such as cDAI or cETH, which is treated as a tax-relevant sale.

Compound

dYdX – is actually a decentralized exchange, but you can also borrow and lend ETH, USDC and DAI. Founded by Antonio Juliano, a former software developer at Coinbase and Uber. The seed financing round was led by Andreessen Horowitz and Polychain Capital.

dYdX

InstaDApp is a decentralized application with which you can interact with different protocols like Maker, Compound or Uniswap Pools.

InstaDApp

DeFi Saver – is another application with a dashboard to interact with MakerDAO, Compound, dYdX or Fulcrum Smart Contracts.

DeFi Saver

Custodial

Nexo is a centralized lending and borrowing platform for crypto and fiat currencies. Not only Bitcoin (BTC), Ethereum (ETH) and other cryptocurrencies can be lent on it, but also US Dollar and Euro. However, fiat currencies are converted into in-house stable coins such as USDx.

Nexo

BlockFi – is another centralized lending platform for Bitcoin, Ether, GUSD, Litecoin and USDC. Of course, you can also get a loan for these cryptos here.

BlockFi

Celsius is a mobile lending app that supports a range of cryptocurrencies such as Bitcoin, Ethereum, XRP, BCH, LTC, XLM, EOS, OMG, 0x and Zcash.

Celsius

 

 

[1] https://medium.com/@philippsandner/decentralized-finance-defi-what-do-you-need-to-know-9cd5e8c2a48

[2] https://defipulse.com/

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