Why are DeFi Gains Hard To Calculate?
DeFi promises that every transaction on the blockchain will be recorded in a decentralized peer-to-peer manner.
That's right. It's an improvement over CeFi (centralized exchanges) that lose records or have closed down.
Unfortunately, the information recorded on the blockchain often makes tax calculations extremely difficult. Scrutiny of blockchain transaction data is required to determine what asset is being traded and the market value in USD.
The protocols, the tax authorities, the service providers, and the taxpayer all create this complexity. In short, in a tax audit, the blockchain is not your friend.
Protocols Create Complexity
Traders blindly believe that everything is recorded on the blockchain, but that is not the case. Protocol writers and smart contract programmers do not think about the tax complexity they create. Each blockchain is very different, which multiplies the complexity.
They use wallet addresses inconsistently, which creates confusion. They frequently make it challenging to correlate transactions and determine the cost basis of assets. It's also difficult to find pricing data for new or exotic tokens.
Determining the basis of NFT transactions can sometimes be difficult. NFT exchanges provide unusable transaction records. When bidding on NFTs, tokens are withdrawn from the blockchain without being associated with the NFT.
A successful bid results in the NFT being written to the blockchain without pricing information. An unsuccessful bid results in tokens being written to the blockchain, which can look more like income than a deposit return.
Unclear Tax Regulations
The application of tax laws to crypto transactions is confusing for many reasons. U.S. tax law focuses on realized gains. Gains are realized when an asset is sold/exchanged, or a financial instrument is closed. For example, is it a taxable exchange if you receive a liquidity pool token in exchange for placing tokens in a liquidity pool?
Since the taxpayer expects to get their tokens back later, does the LP token constitute a crypto-to-crypto exchange or merely a deposit receipt? If it is a deposit receipt, it is not a taxable event, and the original tokens should not have their holding period, and basis changed.
In addition, with novel financial instruments, no gain is realized until the investment is complete. Therefore, treating the underlying coins in the financial instrument as capital gains will lead to misleading tax results. This is especially true for coins that are rebasing and in yield farms.
The rules for taxing derivatives do not apply when the gain occurs on unregulated exchanges. Derivative investments can be held open indefinitely without taxable events occurring. While Congress and the Treasury Department remain vague when it comes to tax regulation of cryptocurrencies, unanswered questions remain about the application of anti-money laundering regulations to the reporting of DeFi investments on non-U.S. exchanges. Regulators at IRS, SEC, CFTC, and FinCEN still have not clarified when security and governance tokens should be taxed like stocks or a commodity.
Service Providers Struggle with Rapid Innovation
Cryptocurrency gain service providers struggle to respond to the explosion of complexity and innovation in the DeFi space. Their applications need to be rewritten entirely to accommodate DeFi.
- New data structures and algorithms are needed to handle derivatives, liquidity pools, impermanent gain, rebasing, and side chains.
- Pricing data on new and esoteric tokens are hard to find.
- Service providers can not always tell when gas fees should be added to the basis.
- The date of constructive receipt is not shown on the blockchain.
Taxpayer Behavior Complicates Things
The biggest source of complexity is the taxpayer.
- They use many wallets and exchanges and often fail to keep good records.
- They even use the same wallet for multiple DeFi and NFT platforms, making it harder to decipher the tax implications.
- They intertwine investments such as staking liquidity pool tokens, which further complicates taxes.
In conclusion, the taxpayer is the one exposed to inadequate transaction tax information. The IRS only needs to prove income or proceeds in an audit. The taxpayer has to prove that they had a cost basis. The blockchain record helps the IRS more than the taxpayer. In an IRS audit, auditors always take a conservative position on the application of the tax laws.
They are not motivated to be sympathetic with your investment complexities. Most IRS crypto audits go all the way to the IRS office of appeals or tax court before they are resolved. In short, in an IRS audit, the blockchain is not your friend.
About the Author
Clinton Donnelly is the founder of Donnelly Tax Law and CryptoTaxAudit. He is a leading expert on income taxes for crypto traders in the US. He has been preparing crypto returns since 2018, and most of his clients are large traders. Clinton has defended traders over 24 times in IRS audits of crypto income. He has authored five books and is a popular speaker.
CryptoTaxAudit provides tools for the average crypto trader to protect their wealth from the IRS. CryptoTaxAudit.com's Audit Defense membership guarantees that our experts will defend the member if they are selected for an IRS audit of their crypto income reporting. They also offer a DeFi Tax Benchmark service for individuals, as shown in this report.