DeFi Accounting: The Dilemma of Yield Farming 2023

1. Dilemma of Yield Farming

Decentralized Finance “DeFi” introduces new financial instruments which have not existed before. These new financial primitives raise many questions as it relates to taxes and financial reporting. There are many innovative financial products built on the blockchain, and today we will focus on Yield Farming. Yield Farming, also known as Liquidity Providing, is the act of depositing assets into a decentralized exchange “DEX” as liquidity for traders. Individuals who provide liquidity, receive in return, trading fees and incentive rewards for their contributed liquidity.

The Tax Liability Dilemma of Yield Farming:

The two largest DEX’s are Uniswap and Curve. Dilemma of Yield Farming Combined, the total value deposited into their smart contracts is approximately 5 billion dollars. This contributed capital is from users across the globe, with no minimum capital contribution requirements. Therefore someone with $10 gets the same deal as someone contributing 10 million.

An issue which arises for liquidity providers “LP” is monitoring their crypto tax liability. Dilemma of Yield Farming The rewards and trading fees are treated as ordinary income and are typically paid out in some asset which is not a stablecoin. Dilemma of Yield Farming It’s common to receive multiple tokens, from different protocol incentive programs. These assets are typically very volatile and can depreciate by 90% during a market turn, leaving an LP without adequate funds to cover their crypto tax liability. If the LP would sell these funds at these depreciated values, it would not help, because this creates a taxable loss, which is limited to 3,000 annual deduction against ordinary income. This is why monitoring one’s tax liability for LP yield income is very important.

What can you do differently to be prepared for tax liabilities Dilemma of Yield Farming?

It is recommended that LP manage their crypto tax liability by selling a portion of the rewards immediately Dilemma of Yield Farming to cover the tax liability at year end. Alternatively, one can sell all the rewards immediately to remove all volatility risk from their position. A simple way to think about this is, when rewards are received, it’s like you received cash, but then decided to purchase the reward asset. Is that your true intention with the yield earned through LP? If holding this asset long-term was not the plan, then selling it immediately is a good practice. Additionally, understanding your tax bracket and entity structure will better prepare you for year end tax liability, and allow you to budget for it accordingly. Dilemma of Yield Farming When an individual’s intention is to hold the reward asset, its vital to keep in mind long-term and short-term durations for gain and loss purposes. This directly impacts one’s tax liability for capital gains/losses. It’s always recommended to consult with your crypto tax accountant, to be sure you are ahead of the game.

Managing  Dilemma of Yield Farming this process and dissecting complex crypto transactions can be overwhelming for even crypto experts. It can be especially challenging for a small business operating on the blockchain to find and afford the talent necessary for this task. A fantastic solution to this problem is OnChain Accounting. OnChain Accounting,is a crypto accounting firm, which provides accounting and tax solutions specifically for crypto businesses. They understand the complexities of digital assets and have 25+ years of traditional accounting experience.

Another important piece to the solution is implementing a strong crypto-sub ledger and crypto tax software. Having a crypto sub-ledger is not optional when operating on the blockchain. Keeping track of tax cost lots and manually importing blockchain transactions is nearly impossible and would take hours, without a crypto subledger. All this can be streamlined with proper software implementation, and managed by a team of crypto accounting professionals, ensuring your financials are accurate and ready to publish.