Liquidity Pool Tax 101: Investor’s Guide 2022
This is a guest post from Coinledger as part of our Partner Spotlight series.
Have you withdrawn or deposited tokens to a liquidity pool?
Given that there isn’t explicit guidance from the IRS on how DeFi is taxed, investors often feel lost when tax season approaches.
In this guide, we’ll break down everything you need to know about how liquidity pool transactions are taxed. We’ll also share an easy way for you to calculate your crypto tax liability in minutes!
The basics of cryptocurrency tax
Before we jump into liquidity pool taxes, let’s go over the basics of how cryptocurrency is taxed.
In the United States, cryptocurrency is considered a form of property subject to ordinary income tax and capital gains tax.
Ordinary income tax: When you earn cryptocurrency, you recognize ordinary income. Examples include earning staking or airdrop rewards.
Capital gains tax: When you dispose of cryptocurrency, you’ll incur a capital gain or loss depending on how the price of your coins has changed since you originally received them. Examples include selling your cryptocurrency or using your crypto to make a purchase.
Typically, crypto-to-crypto trades are also considered taxable disposals of cryptocurrency. In this case, you are disposing of your existing asset for a new asset. (Keep this in mind as we discuss liquidity pool taxes!)
How are liquidity pools taxed?
At this time, the IRS hasn’t given clear guidance on how DeFi transactions are taxed. As a result, tax professionals must rely on existing tax frameworks.
The DeFi landscape is constantly changing, and different protocols use different methods to facilitate liquidity pool transactions. How these transactions are taxed may vary depending on the specific mechanisms of an individual protocol.
To help you better understand how your liquidity pool transactions may be taxed, let’s run through examples of non-taxable and taxable transactions.
Is wrapping your coins taxable?
In some circumstances, crypto investors trade one asset for another that is ‘substantially identical’. It can be argued that these transactions are non-taxable.
For example, consider the following transaction.
Ryan owns 3 ETH.
Ryan swaps his ETH for wETH.
In this case, wETH could be considered a ‘substantially identical’ asset to ETH since they have the same price and can be easily replaced for one another. For this reason, some tax professionals consider these types of transactions to be non-taxable.
How are LP token mints taxed?
On the other hand, it’s reasonable to assume that minting two cryptocurrencies together into a liquidity pool token will be considered a taxable crypto-to-crypto swap.
Let’s take a look at an example.
Robert owns Compound and Ethereum.
He deposits his COMP and ETH in a liquidity pool, and receives redeemable COMP-ETH LP tokens.
In this case, Robert has traded two cryptocurrencies for a new asset that is not ‘substantially identical’ to either one. As a result, it can be argued that this should be considered a taxable crypto-to-crypto swap.
With this position, Robert will incur capital gains or losses depending on how the price of his COMP and ETH has changed since he originally received them.
How are LP token withdrawals taxed?
It can be argued that exchanging your liquidity pool tokens back to your two cryptocurrencies will also be considered a taxable crypto-to-crypto swap.
Consider the following scenario.
Robert swaps his COMP-ETH LP tokens for his COMP and ETH.
Again, it’s not likely that his COMP-ETH LP tokens will be considered ‘substantially identical’ to the COMP and ETH tokens that he is withdrawing.
With this position, Robert will incur a capital gain or loss depending on how the value of his COMP-ETH LP tokens has changed since he originally received them.
Are there different approaches that I can take to report my liquidity pool taxes?
Because of the lack of tax guidance pertaining to the DeFi space, some investors choose to take more aggressive approaches to report taxes on liquidity pool deposits and withdrawals. This may cause issues if the IRS disagrees.
If you have questions on how you may be impacted when you take an aggressive tax position, please reach out to your tax professional.
How to track your liquidity pool transactions for tax purposes
If you choose to manually track your DeFi transactions for tax purposes, you should keep records of the following information:
- Type of cryptocurrency
- The date you received your cryptocurrency
- The date you disposed of your cryptocurrency
- The value of your cryptocurrency at receipt
- The value of your cryptocurrency at time of disposal
- Fees related to acquisition/disposal
However, it’s important to remember that collecting this information requires significant amounts of time and effort.
Another option is to use crypto tax software like CoinLedger. The platform has integrations with hundreds of exchanges and blockchains so that you can import your transactions in minutes. Once you’re done connecting your wallets and accounts, you can generate a complete crypto tax report with the click of a button.
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