DeFi

How to Report Liquidity Mining on Your Taxes

How to Report Liquidity Mining on Your Taxes
by 
Julian Alvarado

Liquidity mining can be a major money-maker. In fact, providing liquidity is the backbone of decentralized finance protocols, and rewards are at a premium these days. But, if you’re a miner yourself, it’s essential that you understand the taxation rules before you blast off. Use this guide to help you avoid any nasty surprises when it comes to the taxation of your liquidity mining income.

What is Liquidity Mining in Cryptocurrency?

Decentralized exchanges need liquidity for enabling trades. Liquidity mining is a mechanism through which people provide their crypto assets to a liquidity pool on a decentralized exchange in return for receiving fees and additional governance token rewards.

For example, Aaron holds 1 ETH and 2,000 USDT in his wallet. He provided his assets as liquidity in the USDT/ETH pair on the Uniswap exchange. Uniswap charges fees of 0.3% on each swap. Aaron will earn this amount as fees if any user swaps assets in the USDT/ETH pair of Uniswap.

How is Liquidity Mining Taxed?

The IRS currently treats cryptocurrencies as property. As a result, disposal (sale, spend or exchange) of a crypto asset will trigger a tax event. The IRS has provided generic guidance on taxability of crypto transactions. However, there is no specific guidance on the taxability of decentralized finance (DeFi) transactions including liquidity mining.

As a result, we need to derive interpretation from existing tax provisions and accordingly determine the taxes.

Liquidity mining can consist of various transactions. Let’s break down each type of transaction and determine the possible tax consequences.

1. You put funds into a liquidity pool

When a user deposits crypto assets into a liquidity pool he receives a Liquidity Provider (LP) token representing the user’s share in the assets of the Pool.

There are two possible tax positions:

A. Conservative: Taxable capital gains

The process of providing liquidity in a pool may be treated as a taxable event since it results in receiving another crypto asset. This is similar to a crypto-to-crypto trade and results in the disposal of an asset thereby resulting in a tax event.

In addition, there is also a possibility that the assets when removed from a pool may not be in the same proportion as they were during the deposit. Hence this stance from a tax point of view would be most appropriate.

For example: Aaron provided 100 USDT & 10 BNB in the USDT/BNB pool of Uniswap and received USDT-BNB LP tokens. In this case, Aaron will record a sale of 100 USDT and 10 BNB and accordingly pay tax on the gains made, if any.

The sale value of the USDT and BNB tokens will now be the cost basis for USDT-BNB LP tokens since it is treated as a crypto-crypto trade.

B. Aggressive: Not taxable

Providing liquidity does not result in the user losing control of his assets nor does it amount to a sale. The mere receipt of an LP token representing ownership of assets is not disposal.

This transaction is similar to creating a Fixed Deposit (FD) in a bank and obtaining an FD Receipt. In the present case, the LP tokens are similar to FD receipts and hence do not accrue any tax liability.

2. You were rewarded with a token representing your funds in the liquidity pool

As mentioned earlier, the benefit of providing liquidity in a liquidity pool is income by way of fees and rewards.

These rewards are taxed as income based on the fair market value of the asset on the date of receipt.

Example: Aaron received 1 BNB as a fee for providing liquidity on April 1. The fair value of 1 BNB on the said date is $350. Hence, Aaron will disclose an Income of $350 in his tax return in Form 1040 - Schedule I - Other Income

3. You removed funds from a liquidity pool

Removal of funds from a liquidity pool would mean disposing of LP tokens and acquiring the two tokens initially provided.

There are two possible tax positions:

A. Conservative: Taxable capital gains

The process of removing liquidity from a pool may be treated as a taxable event since it results in the disposal of crypto assets i.e. the LP tokens. This is similar to a crypto-to-crypto trade and will result in a tax event.

Computing capital gains on LP tokens:

The cost of LP tokens will be the Income recognized on disposal of assets in transaction 1 “You put funds into a liquidity pool”

The sale value of LP tokens will be the Fair value of the two tokens being removed from the pool.

Gains = Sale value - Purchase value

B. Aggressive: Not taxable

When providing liquidity in the pool, we did not treat the transaction as disposal and as a result did not recognise any gains. As a result, we will not realize any income on the removal of liquidity.

Are Liquidity Pools Tax-Free Like Stock-Lending?

In stock lending, the lender loses his ownership of the asset and ceases to receive the related benefits (dividends, voting rights, etc.) for the period of the loan and the borrower of the share acquires the ownership and enjoys the benefits.

This transaction, although it looks like a sell transaction, is not taxable due to a specific section 1058 in the US Tax code.

Even though liquidity mining transactions are similar to stock lending, they do not fall in the ambit of section 1058 since it covers only securities and not crypto assets. Hence, liquidity mining will be treated as taxable under the conservative approach and not taxable under the aggressive approach.

Summary of Tax Treatment for Liquidity Mining

To wrap up the main points:

  1. Liquidity mining provides benefits in the form of income from fees and additional rewards in the form of governance tokens.
  2. Providing liquidity in a pool may be treated as disposal and taxed as per the conservative approach.
  3. Fees and rewards obtained by providing liquidity in a pool are treated as Other Income and the fair market value is taxed.
  4. Removing liquidity may be treated as disposal per the conservative approach and tax would be due.
  5. The benefit of US Tax Code 1058 available to lending and borrowing of securities is not available in the case of crypto transactions.

Manage Your Liquidity Mining Taxes Easily with Bitwave

Depositing into a Liquidity Pool

Here is an example of a transaction on SushiSwap where WBTC and WETH (the ERC-20 version of both BTC and ETH) was deposited into a Liquidity Pool in order to earn liquidity mining incentives in the forms of fees and reward tokens, in this case $SUSHI. 

Since there are many components to this transaction, let's dig into how Bitwave handles it.  

  1. Firstly, Bitwave automatically picks this transaction up as a Defi transaction. 
  2. Next, we have the two tokens we are depositing into the liquidity pool, the LP tokens we are receiving as a receipt of our deposit and we have. 
  3. Once we open up the transaction to categorize it in Bitwave, we can see that there is a lot of detail. Bitwave is actually using the wallet address & the transaction hash to index the smart contract for information regarding this wallet’s specific deposit into the smart contract. Smart contract information is detailed on the right under “Defi Type” within the drop down menu allowing the user to select which method they are calling from the smart contract, in this case we are “Depositing Liquidity.” 
  4. Finally, we can opt to alter the rate the tokens are valued at depending on the context surrounding the transaction, the fee is sent to a fee specific account and there is a check at the bottom of the entry here showing the relevant components of the transaction. 

Typically, after you receive LP tokens, you are automatically eligible to receive rewards in the form of trading fees as these fees are linked to you LP tokens, in order to accrue additional tokens, typically governance tokens, you often need to deposit your LP into another smart contract. This transaction is a simple deposit containing outgoing LP tokens and a gas fee (see below)

Withdrawing from a Liquidity Pool 

Claiming your LP tokens from the contract mentioned above will produce income in the form of $SUHI token and contains a few components, incoming LP tokens, Incoming $SUSHI token and outgoing gas. The main takeaway here is that we can see the $SUSHI token can be categorized as Income once it is claimed. 

Now, after you’ve received the LP tokens and you are looking to unwind back into your original deposit tokens, WBTC & WETH, you will initiate this transaction, which is essentially the reverse flow of the initial deposit. Something to note here is the change in ratio of WBTC and WETH that was received. There was an increase in WBTC received and a decrease in WETH received. 

Bitwave has a GainLoss report and a DeFi ROI report for you to see how the result of this unwind is impacting your Income Statement in the form of the gain in WBTC and the loss in WETH. 

Avoid nasty surprises when it comes to taxes on your liquidity mining. We break down each type of transaction and determine possible tax consequences.

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