May 3, 2021: The Taxman Cometh 🇺🇸💰
Reviewing common DeFi tax questions for crypto-Americans
Check out the sweet growth on this protocol… wanna throw some money into it?
Well, odds are if you’re in the US you’ll get your chance to send money its direction. That’s the projected IRS budget over the next decade.
A lot of people who don’t understand how the world works actually believe an extra $8 billion per year will suffice to snag an extra $380 billion in taxes per year from tax cheats.
In reality, the jerks who are cheating Uncle Sam out of such filthy amounts of money likely won’t have any issue continuing to evade the revenuers. Historically, the IRS has always had a lot more trouble squeezing rich people, because they can afford good lawyers and accountants.
In practice, they always tend to generate their biggest returns by shellacking poor people. The 2020+ money-printing economy appears to amount to open warfare against poor people, which we assume is by design.
So when the IRS again fails to nail rich people in the upcoming years, they’ll be certain to look for any low hanging fruit they can tout as a win. Given the murky guidance around the cryptocurrency space, we can safely predict DeFi users will be squarely in their crosshairs.
We want all of you to be safe and fully tax compliant, and therefore we’re going to share everything we can find about taxes in hope it points you toward prosperity and away from prison!
Of course, nothing in this article should not be considered tax (or financial) advice — you should for sure consult a professional. They may be just as confused as you, but at least they can serve as a human shield to deflect some incoming flak.
So here is an unofficial guide to my best guess based on what I’ve read and various conversations. Not tax advice, but a good forum to raise questions and share links to any answers you’ve found. If you also have researched this and have anything to add please join the discussion!
Like-Kind Swap
If there’s one area of broad agreement in crypto taxes, it’s that the property “like-kind swap” exemption does not apply to crypto. Anytime you trade Dogecoin for Potcoin, it counts as a sale of Dogecoin (with all corresponding capital gains taxes) and a purchase of Potcoin. If the transaction was done on an exchange, just assume they reported this transaction to the IRS (a lot didn’t, but the information could be easily extracted by subpoena). If you transacted off of exchanges, a good rule of thumb is that anytime your transaction writes to the blockchain you owe taxes:
One area that’s more confusing is how to record whether you had a capital gain or loss at the time of your exchange. The tax forms do not require you to state your accounting method, (LIFO v FIFO). If you purchased your $DOGE at $0.01 then bought more at $0.42, and finally sold when $DOGE crashed to $0.25, your wallet is best off claiming last in first out (LIFO), and that you had a bit of a loss at time of sale.
This gives rise to the practice of “tax loss harvesting” — whenever the market dips you sell and immediately rebuy so you have a verifiable transaction demonstrating a transaction at a loss. Although it seems to be legally sound, my biggest concern with this practice is that I can only imagine anybody who tries to claim a giant tax credit for trading cryptocurrency would be among the first to be audited. Even if your argument is technically sound, if the IRS takes you to court, the courts tend to overwhelmingly side with the IRS.
Therefore, the other extreme is to take the most conservative possible accounting strategy — report the acquisition price as zero and report the whole amount as gains. Of course, even if you follow this ultra-cautious strategy, they may still go ahead and attack you anyway, figuring there may be more where that came from. Heads you lose, tails they win.
Constructive Receipt
Airdrops in DeFi pose another interesting tax case. The income becomes taxable at the time of “Constructive Receipt” — the time when a user takes possession of the cryptocurrency and can actually do something with it. The rule of thumb is often that this applies when the airdrop claim hits the blockchain, (presuming the airdrop has such an event).
This would seem to be bad news for the 80% of users who claimed the Ellipsis airdrop. At the outset, $EPS was trading at $10, and claiming the $EPS was a transaction signed and sealed on BSC. The EPS then proceeded to lose over 75% of its value. You could very easily owe as much in taxes on the gains as it ended up being worth after the lock expired. Whoops!
For DeFi diamond hands users who leave their money in pools, the general school of thought seems to be that farming rewards are only realized when you harvest them. Putting $10,000 into, say, Curve’s 3pool and leaving it there probably doesn’t have a tax event until you claim. Here I presume that the 3pool token you receive on deposit is worth its equivalent $10,000, although one could construct a convoluted argument that it is valueless since it’s not really traded on exchanges.
The silly thing is that this is a policy perfectly designed to stifle innovation in the USA. Instead of encouraging money to flow where it can be put to work, such as investments or payrolls, it’s encouraging users to park their money forever into liquidity pools. Thus, it’s only being put to work by innovators in other countries with smarter tax policies and being used to kick our butts. Oh well.
Crypto Lending
Rich people in real life don’t sell, they lend their assets and receive collateral. These loans are generally not taxed unless there is a default event, in which case it becomes income. Similarly, a bunch of crypto lending platforms have popped up. Do they work the same? It’s too new of a concept for there to have been any cases resolving the subject, so it’s tough to say.
Let’s imagine you put $10,000 in DAI into Alchemix, you receive a loan of $5,000 alUSD. Eventually it pays itself off, and you get your $10,000 back. I’ve seen some smart people arguing that this should be tax free as a loan, but I don’t particularly buy it. I personally don’t think the IRS will care to distinguish that you’re calling it a loan, instead pointing to the fact that there’s $5K in income somewhere that needs to be tallied someplace.
If you want to take the more ultra-cautious approach, you could report it to the IRS as:
$10,000 DAI locked, $5,000 alUSD received: gain of $5K
$10,000 DAI unlocked: no tax event
Alternately:
$10,000 DAI locked, $5,000 alUSD received: loss of $5K
$10,000 DAI unlocked: gain of $10K
Or possibly:
$10,000 DAI locked, $5,000 alUSD received: no tax event
$10,000 DAI unlocked: gain of $5K
All three are arguable and would probably make the Feds happy.
If you want to try to claim it as a loan, you probably also have an argument that may be technically correct. But you may only be able to prove it if you bring it before a judge in the court of law, and the courts will generally err on the side of the IRS.
Checking the Boxes
A big change on this year’s tax forms is to ask: “At any time during [the year], did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency”
It’s right at the top of 1040, so nobody can easily plead ignorance. Of course, this question managed to open up even more confusion. The way it’s worded, it could just as easily apply to frequent flier miles or Starbucks points.
Additionally, the IRS’s guidance recommends you check “no” if you bought cryptocurrency with cash, but based on the question’s actual wording above, they seem to be advising you perjure yourself:
People are a bit reticent to check the box because it may open them to heightened audit risk. I’m in the camp that suggests everybody go ahead and check the box. The IRS has shown themselves in the past more forgiving if you are trying to account and commit errors — checking “no” is more an invitation for them to throw the book at you.
Enforcement
The bear of it is, if you end up getting into a fight with the IRS, it’s not a fair fight. Taxpayers win about 14% of the time. It doesn’t even particularly matter if you have the law on your side — they can still make your life miserable, costing you a ton in attorney fees during the excruciating years you’ll be fighting it.
Plus, if they decide not to follow the rules, would anybody stop them? When they nailed Bitcoin Fog, the ends were more important than means:
At the end of the day, everything in crypto is significantly more traceable than fiat. The tools may not exist to trace and understand every transaction today, but the evidence is all in public for prosecutors to construct a case tomorrow. You can understand the present level of sophistication by reading public cases. With an additional $10B in funding each year, it becomes trivial for them to expand on these capabilities to shoot fish in a barrel.
One tool that may be of interest to crypto traders, though I don’t have any experience with any of them, are the membership packages at Crypto Tax Audit, which purport to alert taxpayers of potential audits ahead of time so they can take corrective action in advance. If anybody has any experience it would certainly be interesting to hear.
There’s signs that things may shift again in the future, though it’s unclear which direction. A bipartisan Congress pushed to clarify rules without expanding the scope of any agencies. We can only hope for crypto tax policy to be loosened to actually favor innovation, but we’ll have to wait and see.
For more info, check our live market data at https://curvemarketcap.com/ or our subscribe to our daily newsletter at https://curve.substack.com/. Nothing in our newsletter can be construed as financial or tax advice — consult a professional. Author is a $CRV maximalist.