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February 12, 2021

What is Decentralized Finance? - Explained for Tax Professionals

Decentralized Finance or “DeFi” in short, refers to a collection of financial applications, sometimes called “dapps” (i.e. decentralized applications) leveraging the promise of blockchain technology to perform a variety of financial services such as borrowing, lending, trading, and staking. Staking? Simply put, staking is depositing or “locking” your crypto on a platform to earn rewards like interest in the form of crypto.

Dapps are generally geared towards disrupting the intermediaries (and related costs) traditionally associated with these financial services by offering peer-to-peer transactions. 

It should be noted that if you asked Mr. Google, you’ll quickly find a wide spectrum of varying definitions for DeFi. The world is still trying to define bitcoin and blockchain, so I wouldn’t hold my breath for reaching consensus on the definition of DeFi, just yet.

How Big is DeFi?

According to DeFi Pulse, the total market value of DeFi, as of this writing, is approximately $10 billion “locked” into the wide array of DeFi applications, the largest of which is lending at roughly $4 billion.

Some of the most popular DeFi applications or dapps include lending and borrowing platforms such as Maker and Aave, and then decentralized exchanges (“dexes”) like Uniswap, all of which are built upon the Ethereum blockchain.

How is it taxed?

As regulators are trying to play catch up in the rapidly evolving world of crypto, it shouldn't come as a surprise that DeFi isn’t specifically addressed in the tax code given the novelty of this emerging space. However, that of course doesn’t mean there isn’t existing guidance that can be used to help interpret potential tax implications. 

As one can imagine, the tax treatment of DeFi related transactions can be... well, complicated. And “staking rewards” is an area of hot debate. On July 29, 2020, Congress sent a letter to the IRS stating that its “important that tax policy does not indirectly dissuade U.S. taxpayers from participating in this promising new technology”. The letter went on to say taxing “staking” rewards as income may overstate taxpayers’ actual gains and result in a “reporting and compliance nightmare for taxpayers and the Service alike.”  

As with most regulatory compliance matters, it's usually advisable to err on the side of caution and take a conservative approach. In the case of staking rewards, it would most likely be to recognize income at fair value until further guidance is provided by the IRS. However, the facts and circumstances of each case would of course need to be evaluated. 

With Ledgible Crypto Tax Pro, you can tag token rewards received from activities such as "staking income” to identify and classify these items as ordinary income separately from your capital gains. 

Disclaimer: This post is informational only and is not intended as tax or investment advice. For tax or investment advice, please consult a professional.

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