In the previous lesson, we briefly touched on the tax treatment of NFTs (Non-Fungible Tokens) and DeFi (Decentralized Finance) activities (including staking rewards & yield farming). However, NFTs and DeFi transactions can certainly get quite complex and it’s important for you as a taxpayer to be aware of your tax obligations and understand how certain transactions are handled.

Although NFTs have been around since 2014, they didn’t break through mainstream media until 2021. Over this time, we’ve seen NFTs being traded in the form of digital artwork, audio, in-game assets, real world assets (RWAs) and more - with these NFTs often providing some real-world utility. Below, we’ll analyze the different case scenarios of NFT transactions and how they get treated from a tax perspective.

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NFT Taxes

Example 1: Selling an NFT

Dave bought a Bored Ape in May 2021 for 0.5 ETH ($1000 USD at the time).

He decided to hold onto his NFT and watch the hype build until his Bored Ape was worth 50 ETH ($150,000 USD at the time) in January 2022.

• Dave’s_ c_ost basis: $1,000
• Capital proceeds: $150,000
• Capital gain = Capital proceeds - cost basis = $150,000 - $1,000 = $149,000

In most tax jurisdictions, this profit will have Capital Gains Tax applied.

Example 2: Minting / Buying an NFT

After much success with his Bored Ape investment, Dave decides to try his luck with some upcoming NFT projects. He finds a project that looks promising, completes a few tasks to get onto the whitelist and then mints one of their NFTs for 0.05 ETH.

Now, it’s important to note that minting or purchasing an NFT does not trigger capital gains on the NFT itself.

However, if you purchase an NFT in exchange for a cryptocurrency (just as Dave has done by purchasing his recent NFT for 0.05 ETH), you will actually trigger a capital gains tax on the cryptocurrency used to purchase the NFT as you are ‘selling a cryptocurrency’ (refer to lesson 1).

For example:

• Say Dave originally purchased that 0.05 ETH at a price of $50
• He holds onto that 0.05 ETH for a period of time until he uses (or in other words, ‘sells’) it in exchange for the NFT.
• The value of the 0.05 ETH at the time which he uses it to purchase the NFT is now worth $80
  • Dave’s cost basis on the ETH: $50
  • Capital proceeds: $80
  • Capital gain = Capital proceeds - cost basis = $80 - $50 = $30

Example 3: Trading an NFT for another NFT

Most taxation offices treat NFTs the same as they do cryptocurrencies. Following our example in Lesson 1, trading one cryptocurrency for another triggers a Capital Gains tax event, and therefore the same would apply to NFTs.

• Let’s say you bought an NFT at a price of 1 ETH - worth $2500 USD at the time of the transaction.
• You hold onto your NFT and watch its value drop down to 0.5 ETH.
• At this point, you begin to realize that the NFT project and community may not be as strong as you initially believed and decide to trade your NFT for another, more promising NFT.
• The price of that 0.5 ETH when you traded your NFT is worth $1000.
  • Cost basis: $2,500
  • Capital proceeds: $1,000
  • Capital gain/loss = Capital proceeds - Cost basis = $2,500 - $1,000 = $1,500

Example 4: Creating your own NFT collection (royalties)

Now, say you are an artist and decide to launch your own digital art collection. You learn about the blockchain and realize that creators like yourself can sell your art on an NFT marketplace and receive the majority of the royalties (unlike traditional art sales where the middleman reaps a large portion of the rewards). Most taxation offices view the creation and selling of digital art as an income activity and is therefore subject to income tax.

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DeFi Taxes

Decentralized finance (DeFi) is all about taking away control from centralized institutions like banks and exchanges, and putting ownership and control back in the hands of the asset owners. This takes away the third party risk that comes with trusting a third party with your assets and allows you to have full control & ownership over your assets without the need for a middleman. Users can lend out their crypto-assets, borrow against them or trade them in an entirely trustless, peer-to-peer manner, removing the need for a financial intermediary to facilitate the transactions. Let’s dive into some different types of DeFi activities and have a look at their tax treatment.

1. Lending

A simple case is if you lend a cryptocurrency and get paid interest in that currency as well.

Example 1:

• You lend 5 ETH using a DeFi protocol at a rate of 10%, with the interest you received being denominated in ETH. In this case the interest earned could be classified as ordinary income at the time it was received, using the market value of the ETH at the time.
• You must also take into consideration who controls the funds when you are lending your crypto. If you transfer the funds to a provider who takes control of the funds, this may be considered a taxable event (subject to Capital Gains tax).
• Some DeFi platforms (like Compound) can get a little more complex than that. For example, Compound has their own cTokens which they use to pay interest.

Example 2:

• Say you loan out your ETH into the platform.Your ETH balance will be visible in the currency you deposited but it will actually be held in their cToken - i.e., you will be holding cETH.
• Since there is another token involved, it could trigger a capital gains tax event (just like any other token swap) when you deposit and withdraw funds/ interest.

2. Borrowing

In most jurisdictions, using your crypto as collateral for a loan is not considered a capital gains tax event as long as you still control the funds. However it is important to understand that transferring your funds to a third party to hold as collateral may be considered a loss of control and therefore would be considered a capital gains event. It’s best to check the technical workings of the borrowing platform you are using to see how your collateralised crypto is being handled, and clarify with your local tax authority how your situation is taxed

3. Liquidity Pools

When you provide liquidity to DeFi platforms, you can earn trading fees as compensation. The amount of income you receive depends on the platform’s trading fee and the size of your contribution to the trading pool.

Take a platform like Uniswap or Balancer for example. When you deposit funds into a liquidity pool onto one of these platforms, you receive liquidity pool tokens (LPTs) in return. The value of your LPTs will increase based on the pool’s demand and trading fees, while the amount of LPTs you own remains constant.

If you choose to withdraw your liquidity at a later date, your LPTs will be converted back into the original currencies you deposited. This conversion represents a capital gain event, with the difference between your sell price and your original buy price determining your capital gain or loss.

Example:

• You deposited 1 ETH and 400 DAI into a Uniswap liquidity pool and received LPTs in return.
• Later on, you decide to withdraw your liquidity and receive 1 ETH and 450 DAI.
• The dollar amount of the ETH and DAI would represent your sell price for the LPTs, and the difference between this sell price and your original buy price would determine your capital gain or loss.

Summary for DeFi Transactions

As you’ve seen, DeFi can get quite complex and we’ve only scratched the surface when it comes to DeFi activities that are available. Here are a few things to keep in mind when transacting on a DEX or dApp:

1. If you exchange one token for another this could be a capital gains event,which could include wrapping tokens (e.g., ETH → wETH) and tokens received from the DeFi platform itself (e.g., Compound with their cTokens).
2. If you transfer your tokens to a platform that takes ownership or control of your funds this means technically speaking you no longer hold those funds, therefore you may have triggered a CGT event.
3. If you are airdropped tokens or earn tokens from staking, you may have to pay income tax based on the value of the tokens at the time of the airdrop. If you then hold the tokens, you also have to pay capital gains with the cost base being the value at the time of the airdrop, unless your tax authority treats them as a capital acquisition.

Be sure to check the exact rules that your tax authority will apply to your transactions.