DeFi, or decentralized finance, has experienced unprecedented growth over the last few years, resulting in a market cap of approximately $85 billion as of October 2021. Built on blockchain technology and cryptocurrency, DeFi has the potential to revolutionize finance by allowing users to borrow, lend, trade, and execute other financial transactions without a centralized authority or financial intermediary. Despite its popularity, the IRS has yet to issue specific guidance on how DeFi transactions should be viewed from a tax perspective. Fortunately, Notice 2014-21, which the IRS originally issued in 2014 and updated this year, can shed some light on how certain transactions conducted on DeFi platforms should be taxed.
In this posting, we will briefly explain what DeFi is and the tax implications of common DeFi transactions, including staking, lending, and yield farming/liquidity mining. It is important to note, however, that the taxation of DeFi transactions is an evolving area and future IRS guidance could supersede or clarify the principles laid out by the Service in Notice 2014-21.
What is DeFi?
Silicon Valley has long been the de facto location for budding startups to set their roots and grow into multimillion-dollar businesses, but it may not be the capital of blockchain technology. As of July 2017, 62 out of the 105 total U.S. companies valued at over $1B are located in California. To put that into perspective, New York has the second highest amount with only 15 businesses.
Leaving Silicon Valley
However, with the power of decentralization, blockchain-based startups are proving that you can find success outside of the Silicon Valley bubble. Cities around the world, whether it be through looser regulations, strong financial ties, or some unknown factors, have started vying for the title of “capital of blockchain” and are emerging as meccas for young cryptocurrency companies. Although a forerunner hasn’t emerged yet, there are a few regions beginning to develop as hot spots for this new innovation.
Over the last several years, virtual currency has become increasingly popular. Bitcoin is the most widely recognized form of virtual currency, also commonly referred to as digital, electronic or crypto currency.
While most smaller businesses aren’t yet accepting bitcoin or other virtual currency payments from their customers, more and more larger businesses are. And the trend may trickle down to smaller businesses. Businesses also can pay employees or independent contractors with virtual currency. But what are the tax consequences of these transactions?
Bitcoin has an equivalent value in real currency and can be digitally traded between users. It also can be purchased with real currencies or exchanged for real currencies. Bitcoin is most commonly obtained through virtual currency ATMs or online exchanges.
Goods or services can be paid for using “bitcoin wallet” software. When a purchase is made, the software digitally posts the transaction to a global public ledger. This prevents the same unit of virtual currency from being used multiple times.
We are in the midst of a “Fourth Industrial Revolution” in which technology is advancing at an exponential pace, bringing us mostly digital tools and processes. In the tax world, “digital” translates to: “how do rules designed for a tangible world apply?”
Cryptocurrency is a great example to remind us that tax as well as other laws and compliance processes need to be fluid to keep our economy moving ahead. Inaction or inappropriate responses can shut down or decelerate advancements that benefit society and lead to further technological progress.
From the late 1960s, when software was decoupled from hardware, to the birth of bitcoin nearly a decade ago, what have we learned that can help us deal with this asset and its uses as we encounter even more new forms of technology, uses and ways of doing business? This article suggests four tax lessons.
What is money? Money is a measurement unit for the purpose of exchange. Money is used for valuation of goods, settling debts, accounting for work performed, and standardizing the measurement of production. Money has to be divisible, portable, stable in value, easy to obtain, durable over time and must be trusted by all parties using it.
Imagine money that is too large to divide into pieces, heavy to carry, spoils after 2 days, gets damaged easily or can be eaten by animals? If these are the characteristics of the currency, it would not be that useful and many business deals would not happen.
The most important element of money is trust. If you work for someone and you are not sure if you will get paid, would you do the work? If you did the work, and you got paid for something that was not accepted in many places, is it a valid payment? The economy and money system are built on trust, and it can be broken by a lack of trust by the majority of people.
With the price of Bitcoin hitting record highs in 2017, many Bitcoin holders cashed out not realizing the impact it could have on their tax bill. Many people, for example, did not understand that it was a reportable transaction and found themselves with a hefty tax bill–money they may have been hard-pressed to come up with at tax time. Others may have been unaware that they needed to report their transactions at all or failed to do so because it seemed too complicated.