DeFi lending has quickly become one of the most popular ways to earn passive income in crypto. But with growth comes the inevitable question: how does the IRS treat DeFi lending and borrowing for tax purposes?
At Count On Sheep, we help investors cut through the noise. The IRS doesn’t recognize DeFi as a tax-free zone. In fact, most transactions tied to DeFi lending and borrowing can create a taxable event—meaning you may owe income tax or capital gains tax depending on how the transaction is classified. Understanding these rules is the difference between staying compliant and facing penalties down the road.
This guide explains:
The basics of DeFi lending and borrowing
The most common taxable events in DeFi
How capital gains and income tax apply
Practical steps to lower your tax liability
By the end, you’ll know exactly what the IRS expects and how to protect your gains with proper reporting.
DeFi is taxable – Lending, borrowing, staking, and liquidity pool activity often create taxable events.
Income vs. capital gains – Rewards like tokens or interest are taxed as ordinary income, while trades and swaps are subject to capital gains tax.
Borrowing itself isn’t taxed – Taking a loan with crypto collateral isn’t taxable, but liquidation or repaying in a different asset can be.
Record-keeping is critical – The IRS requires accurate reporting of your fair market value and cost basis at every step.
The IRS is watching – Expect enforcement through 1099-DA forms and blockchain tracking tools.
Decentralized finance (DeFi) allows people to lend, borrow, and trade without banks or brokers. Instead, smart contracts on DeFi platforms manage the transactions.
Lenders deposit crypto into a liquidity pool and earn interest payments or token rewards.
Borrowers take defi loans using their crypto as collateral, sometimes receiving wrapped tokens or governance tokens in return.
These DeFi protocols are designed to automate financial transactions. But for tax purposes, the IRS treats most DeFi transactions like traditional finance—meaning they often create a taxable event.
The short answer: yes, DeFi lending can be taxable.
Here’s how it works under IRS rules:
Earning interest or rewards – If you earn new tokens from liquidity mining, staking rewards, or yield farming, the fair market value of those tokens at the time you receive them is considered taxable income. You may owe ordinary income tax on these earnings.
Capital gains tax – When you withdraw your crypto from a liquidity pool, trade liquidity pool tokens, or swap assets on DeFi platforms, you may trigger a capital gains tax event. If the asset appreciated, you’ll pay capital gains tax based on your cost basis and market value at the time of disposal.
Borrowing funds – Taking out borrowed funds with your crypto as collateral is not a taxable event, since you’re not selling the asset. But liquidations, wrapped tokens, or repayments in different assets can create taxable transactions.
The tax implications of DeFi are complex, but most activity is either subject to capital gains or considered taxable income.
Let’s break down some of the most common DeFi transactions and how they are taxed:
Depositing crypto into a liquidity pool often creates a taxable event because you’re exchanging your tokens for liquidity pool tokens.
This counts as a crypto transaction where the IRS may view it as a disposal. You’ll calculate your gain or loss using the cost basis vs. fair market value of the asset at the time.
Rewards from liquidity mining or yield farming are crypto income.
They are taxed at your ordinary income tax rate, based on the fair market value when received.
If you later sell those tokens, you may also owe capital gains tax on any increase in value.
Staking rewards and interest payments from DeFi lending are treated as taxable income when received.
This means they are considered taxable income at the time you earn them, not when you sell them.
Taking out defi loans with your crypto collateral is not immediately taxable.
But if your collateral is liquidated, or if you repay the loan in a different underlying asset, that can create a taxable transaction.
Exchanging ETH for wrapped tokens like wETH may be treated as a crypto-to-crypto transaction.
Receiving governance tokens as rewards can be treated as ordinary income, taxable at receipt.
To make this clear, here are examples of how defi taxes work in practice:
Example 1: You deposit 1 ETH into a liquidity pool and receive LP tokens. This swap is a taxable event because you exchanged one crypto asset for another.
Example 2: You earn 100 USDC from lending on a DeFi platform. That $100 is taxable income at your ordinary income tax rate.
Example 3: You later sell the LP tokens for more than your cost basis. This triggers a capital gains tax event, and you must calculate gains and losses.
Tracking defi transactions is not simple. Each taxable event—from earning tokens to swapping them—requires you to know:
The fair market value at the time of the transaction
Your cost basis for the asset
Whether it’s ordinary income or capital gains
This is why many investors use crypto tax software to track transaction history across defi platforms. Tools like Koinly, CoinLedger, and ZenLedger help ensure accurate tax reporting and simplify crypto tax reporting.
While you can’t avoid crypto taxation, you can manage your overall tax liability:
Tax-loss harvesting – If you have crypto losses, you can sell them to offset capital gains and reduce taxable income.
Hold more than a year – Holding DeFi tokens for more than a year may qualify for long term capital gains rates, which are lower than short term capital gains.
Donate crypto – Donating crypto directly to a qualified nonprofit lets you take a tax deduction on the fair market value and avoid capital gains tax.
Borrow instead of sell – Using borrowed funds lets you access liquidity without triggering a capital gains tax event.
Work with a tax professional – A tax advisor can help you reduce your crypto tax bill and avoid mistakes that may look like tax evasion.
At Count On Sheep, we help you stay compliant with IRS rules while finding ways to lower your defi tax burden.
We guide you through common defi transactions like lending, staking, and yield farming.
We calculate your fair market value, capital gains, and taxable income with precision.
We provide accurate tax reporting so you can file a clean tax return.
Don’t lose sleep over DeFi lending taxes. Our team of crypto CPAs and advisors will help you stay compliant, save more, and reduce stress.
Borrowing itself is not taxable. But liquidation or repaying with a different underlying asset can be.
Yes. Rewards from a liquidity pool are taxable income at receipt.
The IRS tracks DeFi using crypto exchanges, 1099-DA forms, and blockchain analytics. They expect full defi tax reporting.
Yes, exchanging assets for wrapped tokens can create a taxable event since it’s a crypto-to-crypto swap.
You cannot legally avoid them. But you can reduce your tax liability with tax loss harvesting, long-term holding, and strategic planning.