Tax treatment of DeFi activities

Decentralised financial markets (DeFi) are becoming increasingly important and offer investors a promising alternative to traditional financial systems. With attractive opportunities such as lending, staking or using liquidity pools, there are numerous ways to generate passive income in the crypto world.

However, alongside the many opportunities, tax obligations must not be neglected. Correct documentation of DeFi activities is crucial to avoid tax risks. In this article, we provide you with an overview of DeFi and explain what you should be aware of in terms of taxation.

What is included in DeFi?

DeFi (decentralised finance) aims to create an open, globally accessible financial system. The term encompasses various financial services based on blockchain technology that enable traditional financial services such as lending, saving, investing and trading without the need for central institutions such as banks or brokers.

Instead, smart contracts are used to process transactions securely and automatically. Users can participate in the trading of cryptocurrencies and other decentralised assets worldwide via decentralised exchanges.

Important features of DeFi are:

• Decentralisation: no central authority controls the system. Financial processes run on decentralised networks and protocols.
• Transparency: All transactions are visible on public blockchains.
• Accessibility: Anyone with an internet connection and a crypto wallet can use DeFi services, regardless of geographical or financial restrictions.
• Automation: Smart contracts automate many processes, eliminating the need for intermediaries.

DeFi and taxes

If I, as a private individual, generate income in connection with DeFi providers, the question of how to pay tax on it always arises. The topic of DeFi and taxes can be very complex, even though the profits generally count as income and are therefore subject to income tax. However, you need to consider the following aspects and questions regarding DeFi taxation:

• Which type of transaction is affected?
• Holding period
• What DeFi activity is involved (e.g. lending, staking)?

Also keep in mind that you can claim transaction fees incurred in DeFi activities as tax deductions.

DeFi and holding periods

Capital gains on cryptocurrencies held for more than a year remain tax-free. For shorter holding periods, capital gains are subject to income tax if they amount to at least €1,000 per year.

Taxation of various DeFi activities

The tax authorities in Germany have commented on certain aspects of cryptocurrencies and DeFi, but there is still ambiguity, particularly in special constellations related to the transactions.

Some examples of DeFi activities and their tax treatment:

Taxes on staking

If you make cryptocurrencies available to the network to validate transactions for a certain period of time, you will receive a reward for doing so. This can be treated as other income. Taxation usually occurs as soon as the rewards are paid out. The individual tax rate is applied to this income. The exemption limit is €256.

If you operate staking nodes yourself, the income generated by this can also be taxed as commercial income.

Lending taxes

If you lend your cryptocurrencies to other users and receive something in return, this income is considered income and is therefore also taxable. The taxable amount is calculated by converting the market value of the coins or tokens into euros at the time of receipt. The exemption limit is €256.

Taxes for liquidity mining

If you provide cryptocurrencies to a liquidity pool and receive rewards for them, this is usually considered a disposal of cryptocurrencies. The gain or loss is calculated based on the time at which the cryptocurrency was added to the pool. However, if the cryptocurrency provided has been held for more than a year, you do not have to pay taxes.

Please also note the following for liquidity mining:

• Regular income from this DEFI activity may be treated as either other income or capital gains.
• The withdrawal of coins/tokens from the liquidity pool may also be relevant for tax purposes, namely if the asset value has increased since the contribution. In this case, you will have to pay tax on this increase in value at your personal income tax rate.

Taxes on token swaps

Cryptocurrency swaps are taxable transactions, as the swap is considered a sale and subsequent purchase. This applies to swaps involving fiat currencies as well as swaps between different cryptocurrencies. The taxable profit is the difference between the sale value and the purchase value of the respective cryptocurrency.

Taxation of cryptocurrencies when used as a means of payment

When cryptocurrencies are used within DeFi protocols to pay for services or products, this constitutes a taxable disposal. The difference between the purchase price and the sale price is taxed.

Tax documentation of transactions, profits and losses

It is important that you accurately document all transactions, profits, losses and rewards in order to properly complete your tax return. Keep supporting documents for at least 10 years.

The following are important:

• Date of purchase and sale
• Quantity traded
• Value at the time of transaction
• Wallet addresses involved

Conclusion on the topic of DeFi and taxes

The DeFi universe offers investors numerous exciting opportunities, many of which can generate attractive passive income. However, with the wide range of options also come complex tax requirements.

It is essential to maintain complete and accurate documentation of all activities in order to fulfil tax obligations. It is also important to check carefully whether certain DeFi activities, such as staking or operating nodes, could be categorised as commercial activities.