DeFi Lending: Recursive Tax

Yield Everywhere

Decentralized Finance (DeFi) has taken the world by storm, offering unprecedented opportunities to engage in collateralized lending and borrowing with rates far exceeding traditional markets. 

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At the heart of this ecosystem lie protocols like Aave, which allow users to deposit their crypto assets and watch them grow like a digital Chia Pet, or borrow against them to finance their ventures. However, the tax implications of participating in DeFi lending can be as complex as they are exciting.

Interest Income

In traditional finance, the tax treatment of borrowing and lending is relatively straightforward. Interest income and expenses are just that, they do not magically transform into capital gains. But in the wild west of DeFi, their unique implementations can create a tangled web of tax consequences.

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One particularly intriguing aspect of DeFi lending is recursive lending, which can be best described as "borrowing from yourself to lend to others." This creates a loop of transactions that can leave seasoned tax professionals scratching their heads. The complexity is further compounded by the various ways in which platforms account for interest. When depositing funds into some platforms, users receive a “receipt” that is usually another token with a slightly different name. For example in Aave, depositing USDC would get you aUSDC, and cUSDC in Compound. Some of these tokens are rebasing and automatically increase in quantity, while others opt for fixed token amounts that gradually accrue value. In either case they are used to track how much money is owed to the depositor, but they could imply dramatically different tax treatments when looked at from a literal token transfer perspective.

Income as Capital Gains

Most tax software treat DeFi lending transactions as trades, potentially triggering capital gains or losses where none may have actually occurred. This literal interpretation of the smart contract's activities can lead to a significant overstatement of tax liabilities, particularly during times of high market volatility.

But it can also do the reverse! Protocols such as Compound don’t use rebasing tokens, their value simply increases over time. This makes it look like owning a stock that’s growing slowly. So if you don’t sell them, you don’t get taxed right? Well, there lies the problem. Should tax liabilities change simply based on how DeFi protocols implement their internal accounting? I sure hope not!

Proper Accounting

Fortunately, solutions like PennyWorks are emerging to help financial professionals navigate the complex tax landscape of DeFi lending. By treating these activities as what they truly are – lending transactions – PennyWorks can match more closely the intent of the financial activity and create more defensible books and records. To accomplish this:

• User deposits and withdrawals can be recorded in the underlying currency being lent (USDC), not as the resulting receipt token (aUSDC).
• Income should be captured periodically reflecting the continuous compounded nature of DeFi lending.
• Recursive lending simply increases leverage, and inflates both sides of the balance sheet.

This not only helps users avoid the pitfalls of literal interpretations but also ensures that they can participate in the DeFi lending market with greater confidence and peace of mind.

Conclusion

As the DeFi ecosystem continues to evolve and mature, financial professionals who stay informed about the tax implications of their activities will be best positioned to capitalize on the opportunities presented by this exciting new frontier. Be sure to check out our other blogs to learn more about DeFi as we continue this series in the following weeks!