Crypto Terms and Taxes Simplified for 2021

Crypto Terms: What is DeFi?

DeFi is short for the crypto term “decentralized finance.” It is a cryptocurrency market in which public blockchains  create financial services for users. What makes this financial sector decentralized is its lack of reliance on centralization. There is no requirement to access your crypto through a third-party intermediary, such as a bank or broker. Instead, you can borrow, trade, and lend your crypto globally. The blockchain protects your transactions and thwarts the possibility of external interference, such as theft.

Through DeFi, you eliminate bank fees, increase your financial security, and move your money anonymously.

Liquidity in Crypto Terms

In the financial sector, an asset’s “liquidity” refers to its ability to be converted into cash. In crypto terms, liquidity considers whether there is a significant discount or premium being placed on a crypto when buying or selling it. A high discount would suggest that the crypto is severely undervalued, while a premium suggests that the crypto is overvalued. In the crypto market, stable and transparent prices (and the consistent liquidity levels) are important for user confidence.

Crypto Terms: Lending

DeFi allows you to lend out your cryptocurrency assets to other users. This results in a yield, which means that you make (or lose) income based on that action. As with all income, the IRS sees it as taxable. Depending on how the lending was conducted, the IRS will treat your spending as regular income or capital gains. Both of these are taxed differently.

Regular Income

A plain run of the mill lending activity- that is, loaning crypto with the understanding of repayment plus interest- is simple. Any income which you earn from such an activity is treated as regular income. It will be taxed at your income tax level, which means that it varies based on total income and marriage status.

Capital Gains

Some DeFi platforms are not paying interest directly into your crypto wallet. These platforms choose to issue Liquidity Pool Tokens instead, which are a pool of tokens which the platforms use to create an efficient trading environment. A liquidity pool is an automated market maker, and the pool’s supply of liquidity helps prevent large fluctuations in the pricing of a cryptocurrency, such as Bitcoin. 

When you are issued a LPT by a DeFi platform, know that it represents your stake in that liquidity pool. You are not being paid interest, but the value of your LPT grows as the liquidity pool earns interest. You will need to pay capital gains taxes when you trade in your LPT for another crypto currency.

If you have any questions on how capital gains taxes on crypto work, always feel free to reach out to a tax professional.

Yield Farming

While we are on the topic of the effect of liquidity, now is a good time to talk about yield farming. By leveraging crypto assets, a user aims to generate positive yields passively. Simply put, you add your token to a DeFi platform’s liquidity pool and earn interest on it. This process is remarkably similar to the traditional savings account. You left your money with the bank, and the bank used it to lend money to its customers. In return, the bank provides you with interest.

Of all the crypto terms to remember, this is an important one. Since it is so easy to do, yield farming can act as a great passive income opportunity for users. How much of your crypto you dedicate to yield farming, however, depends on your financial situation. Don’t hesitate to connect with a tax pro if you ever have questions.

Crypto Terms: Borrowing

Just as you can lend your cryptocurrency, you can also borrow it. You will have to put up your underlying crypto assets as collateral for the loan BEFORE the lender consents to the loan. Because the money which you borrow from a lender will have to be paid back, the federal government does not consider this a taxable event. No capital gains or income taxes will be applied.

In the crypto world, however, there is often a lot of price fluctuation. If the underlying crypto asset’s price takes a dramatic dip in the crypto market, then the lending platform will be forced to liquidate your collateral. This is taxable to you! The IRS will treat the sale as short-term or long-term capital gains. This depends on the length of the holding period for your collateral.

Governance Tokens

Governance tokens are crypto terms which are rarely talked about, but serve an important function in the crypto market. A governance token allows the user to make decisions about the future of the protocol which issued the token. Like a shareholder of a company, your single coin allows you to take responsibility for the coin’s future.

DeFi protocols like MStable or Compound distribute governance tokens, which are taxable upon receipt. Your taxable income is determined by the fair market value of the coin at that time. Once a governance token is given, you may sell it on the market, or trade it in for USD. However, be aware that you will incur a capital gains or loss tax for this activity!

Crypto Terms: Gas Fees

The last but not least of our crypto terms is gas. Gas is a fee which is paid when using the Ethereum blockchain platform. These fees are labeled as gwei and priced in small fractions of ETH. They reduce the total income earned from selling a cryptocurrency or executing a swap, which means your taxable income will be lowered.

Yoke Tax employs top professionals in the field of accounting for complex topics such as these. Each tax pro has over 20 years of experience and is more than willing to help you with any questions you might have. Simply set up a free consultation and let us take care of the numbers.