An Introduction to DeFi

Decentralized Finance (DeFi) is a rapidly evolving space, offering blockchain-based financial applications that enable individuals and businesses to access various financial services, including lending, borrowing, trading, and earning interest without traditional financial institutions as intermediaries. By leveraging smart contracts and decentralized networks, DeFi aims to create an open, transparent, and accessible financial system.

In this guide, we will explore a variety of use cases for DeFi and their associated taxes, including:

Understanding these concepts and applications will help you better navigate the DeFi ecosystem, especially regarding any tax liabilities you may incur when participating in DeFi transactions. If you’d like to learn more about DeFi taxes as it relates to your personal situation, contact a Harness Tax Advisor today.

Overview of DeFi Use-Cases and Their Tax Implications

Before diving into specific tax implications, it is essential to understand the various DeFi use cases and their potential tax consequences. Here are some of the most common:

Token Swaps

Token swaps involve exchanging one cryptocurrency or crypto asset for another on decentralized exchanges (DEXs) or through automated market makers (AMMs). These swaps are treated as taxable events, similar to traditional crypto-to-crypto trades. The difference between the fair market value of the acquired asset and the cost basis of the disposed of asset is subject to capital gains tax.

An example of a token swap is exchanging Ethereum (ETH) for Chainlink (LINK) on a decentralized exchange (DEX) like Uniswap, which uses an automated market maker (AMM) mechanism to facilitate the trade.


Staking involves locking up tokens in a smart contract to participate in network validation and earn rewards or financial compensation. Staking rewards are considered taxable income at the time of receipt, and their fair market value should be reported as income on your tax return. The cost basis of the staked tokens remains unchanged, and any capital gains or losses will be realized when the tokens are eventually sold or exchanged.

One example of a staking platform is Avalance (AVAX), which recently partnered with Amazon to power blockchain infrastructure for government, enterprise, and institutional users of Amazon Web Services (AWS).

Lending and Borrowing

DeFi platforms enable users to lend and borrow crypto assets. When lending assets, the interest earned is considered investment income and is subject to ordinary income tax. Borrowing, on the other hand, similar to traditional cash loans, does not trigger a taxable event unless the borrowed funds are used to acquire more crypto assets. In that case, the transaction would be considered a margin trade and may have tax implications based on capital gains or losses.

Yield Farming

Yield farming is the process of providing liquidity or staking assets in DeFi protocols to earn rewards, often in the form of governance tokens. Yield farming can result in taxable income in the form of governance tokens or other rewards. These rewards must be reported as income based on their fair market value at the time of receipt.

The main difference between yield farming and staking is that yield farming typically involves providing liquidity to a pool to facilitate borrowing and lending, while staking involves locking up tokens in a wallet or delegating them to a stake pool to support a Proof of Stake (PoS) blockchain’s consensus mechanism.

Liquidity Pools

Liquidity pools are groupings of tokens locked into smart contracts that facilitate token swaps and provide liquidity to DEXs and AMMs. When you provide liquidity to a pool, you typically receive liquidity pool tokens (LP tokens) representing your share of the pool. When you eventually withdraw your assets from a liquidity pool, the difference between the value of the withdrawn assets and the initial cost basis may be subject to capital gains or losses.

When providing liquidity to a pool, you receive LP tokens representing your share of the pool. The tax implications of liquidity pools arise when you withdraw your assets from the pool, as the difference between the value of the withdrawn assets and the initial cost basis may result in capital gains or losses.

Non-Fungible Tokens (NFTs)

Though not inherently DeFi projects, NFTs, or Non-Fungible Tokens, have made a substantial impact in the DeFi world, especially in representing membership or access rights within platforms and online communities. For instance, NFT-based membership tokens like Bored Ape Yacht Club (BAYC) not only provide users with unique digital art ownership but also grant them exclusive access to events, content, and governance rights.

Governance Tokens

Governance tokens, such as AAVE, are used to represent voting rights within a DeFi platform or protocol. Acquiring governance tokens can be a taxable event if received as a reward for participating in DeFi activity, such as yield farming or staking. The fair market value of the governance tokens at the time of receipt should be reported as taxable income.

As mentioned earlier, acquiring governance tokens may be a taxable event if received as a reward for participating in DeFi transactions. The fair market value of the governance tokens at the time of receipt should be reported as taxable income.

Decentralized Autonomous Organizations (DAOs)

Decentralized Autonomous Organizations (DAOs) are blockchain-based organizations governed by their members through voting mechanisms. Participation in a DAO can result in taxable income, similar to governance token rewards, and is considered by the IRS to be self-employment income for tax purposes. This classification may impact tax liabilities for DAO participants, as self-employment income is subject to self-employment tax in addition to regular income tax.

Tax Code Changes for DeFi in 2023

For the 2023 tax year, the U.S. tax code has introduced several changes that impact DeFi participants, including:

  1. Clarification on Taxable Income: The IRS has provided further clarification on the treatment of various DeFi-related incomes. Staking rewards, yield farming rewards, governance token rewards, and similar incomes are now explicitly considered taxable income at the time of receipt. This update helps to eliminate any confusion surrounding the tax treatment of these types of income.
  2. Mandatory Reporting of All Virtual Currency Transactions: The IRS now requires taxpayers to report all virtual currency transactions, including those involving DeFi activities, regardless of the transaction amount or whether the transaction results in a gain or loss. This change emphasizes the importance of maintaining comprehensive records of all your DeFi transactions to ensure accurate reporting on your tax return.
  3. Revised Tax Brackets and Rates: The IRS has updated the tax brackets and rates for 2023 to account for inflation. These changes may affect your overall tax liability, depending on your income and the specific DeFi activities you engage in. It is essential to stay informed about these updates and adjust your tax planning strategies accordingly.
  4. Increase in Standard Deduction: The standard deduction amounts have been increased for 2023, which may impact your overall tax liability, especially if you do not itemize deductions. Be sure to consider these changes when planning for your DeFi taxes.
  5. Form 1099-NEC and DeFi Income: The IRS has clarified that certain DeFi income, such as income earned from participating in a Decentralized Autonomous Organization (DAO), is considered self-employment income and should be reported on Form 1099-NEC. If you receive a Form 1099-NEC for your DeFi income, be sure to include this information on your tax return.

Relevant IRS Tax Forms for DeFi Taxes

In addition to 1099 forms, here are two other IRS tax forms you should know about before diving into DeFi

Minimizing Taxes on DeFi Transactions

In addition to understanding the tax implications of DeFi transactions, it is crucial to explore strategies to minimize your tax liabilities. Common approaches to consider include:

    1. Tax-loss Harvesting: Offset capital gains by selling or exchanging assets with losses. Maintain accurate records to identify tax-loss harvesting opportunities.
    2. Long-term Capital Gains: Hold assets for over a year for favorable long-term capital gains tax rates, especially if you’re in a higher tax bracket.
    3. Utilize Tax-advantaged Accounts: Consider using tax-advantaged accounts, such as IRAs or 401(k)s, for investing in certain crypto assets, as this may help defer or minimize taxes on gains and income.

Work with a Harness Tax Advisor

DeFi offers exciting opportunities for participants in the decentralized financial ecosystem. However, it is essential to understand the tax implications of DeFi transactions and ensure compliance with the latest tax code changes, particularly as the industry continues to rapidly evolve.

At Harness Tax, our advisors understand the complexities of DeFi taxes and are committed to helping our clients navigate the ever-evolving tax landscape. If you need assistance with DeFi taxes, or want to learn more about our full range of services, join Harness Tax and get matched with an experienced crypto-focused accountant today.

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This document does not constitute advice or a recommendation or offer to sell or a solicitation to deal in any security or financial product. It is provided for information purposes only. To the extent that the reader has any questions regarding the applicability of any specific issue discussed above to their specific portfolio or situation, the reader is encouraged to consult with the professional advisor of their choosing.