The IRS has not issued any guidance on the taxation of liquidity pools. That said, there are a few prevailing theories on whether or not the entry into and exit out of the LP are taxable events, which we will discuss in this article. The earnings within the pool itself are taxable income.
No IRS Guidance on Liquidity Pools (LPs)
I’ve been writing other articles instead of this one for a while. Not because there is not an answer to how LPs are taxed, but because that answer is more muddled than the topics we’ve already written about.
Lack of IRS guidance in crypto is nothing new: the IRS has not issued guidance on staking, nodes, or NFTs either. But with all of those other topics, there was something analogous within established case law that we could reference against.
That’s still true with liquidity pools, but we’re straying further from those precedents. There isn’t an obvious non-crypto equivalent to LPs. They function in a way that is much more specific to crypto.
How Liquidity Pools Work
We aren’t going to get into an in-depth discussion of the technical aspects of how LPs function. This has already been covered in-depth in existing articles and training programs/communities. In this article, we’re going to be focusing almost exclusively on how LPs are taxed.
And for the purpose of this discussion on taxation, the extreme TL;DR of LP mechanics that you need to understand is that:
- You are depositing crypto assets into a pool and are receiving a share of that pool’s earnings in return. In some protocols, you are actually receiving “LP tokens” in return for your contribution. As an example, if you contributed even amounts of ETH and BTC into a liquidity pool you could be rewarded with ETH/BTC LP tokens. In other protocols like THORChain, LP tokens are not issued but the general process works the same way
- This liquidity (yours and others who contribute to the pool) allows the Automated Market Maker to execute autonomous trades
- The pools are designed to be evenly split between two crypto tokens and are constantly recalibrating to maintain that ratio. This price fluctuation between the value of the two assets can lead to something call “impermanent loss” or “divergent loss”. LP University has an excellent guide on how impermanent loss works
- As a reward for depositing your crypto into the LP (and taking on the risk of impermanent loss), the protocol will give liquidity providers a percentage of the trading fees the LP charges
Certain components of LP taxation are straightforward. The trading fees you receive are of course taxable income. But the mechanics of how LPs work pose some much more difficult questions. Namely: what happens when you enter or exit an LP? Are those taxable events?
Is Lending Money Into the Liquidity Pool Taxable?
At face value, the answer to this seems very obvious. When is lending money ever a taxable event? Or framed another way: when is purchasing a non-depreciating asset a taxable event?
In most cases, the answer is “never”. Lending money (or borrowing money for that matter) is not a taxable event in most cases. The only taxable income from that transaction is when you receive interest payments.
So why would LPs be any different? All you’re doing is lending funds into the protocol…right?
Sort of.
Again, the mechanics of LPs become important here. Because when you’re contributing to an LP, you are giving up your regular crypto and are receiving an equal value of LP tokens. For most of our examples in this article, we’re just going to say you’re contributing ETH.
Put another way: it is at least reasonable to argue that you are trading your existing ETH for a different cryptocurrency. And as we know, coin for coin trades are taxable.
There are two different stances that you can take on the contribution to an LP:
- Conservative: you disposed of ETH and purchased a new token. Like all other coin for coin trades, this is taxable
- Aggressive: you are simply lending ETH into the protocol as collateral. You have no intention of selling any LP tokens received. And like any other lending activity, this is not taxable
Note: in this article we talk about the receipt of LP tokens when entering the pool. But for protocols like THORChain where LP tokens are not actually received, the taxation is the same. Your entry/exit from the pool can be treated as buying/selling access to it (taxable) or that you are lending funds/recalling a loan from it (not taxable). The issuance of actual LP tokens is not required.
Again, neither one of these stances is inherently right or wrong. And the IRS has issued no guidance. The right approach will largely depend on the particulars of the protocol you are depositing into as well as your personal risk tolerance.
Is Wrapping a Token Taxable?
Certain protocols require that your tokens be “wrapped” before you can deposit them into an LP. A good example of this is Bitcoin. BTC operates on its own blockchain, so if you’re wanting to deposit onto a different protocol like Ethereum, in some cases you’d first need to wrap your BTC into wBTC.
Wrapped tokens stay the same price as their non-wrapped counterparts. But they operate on a different network.
So is this taxable?
Again, there are two basic stances you can take here:
- Conservative: BTC is a separate and distinct asset from the wBTC with different utility. This should be treated as a regular, taxable coin for coin trade
- Aggressive: your wBTC is simply a placeholder for your existing BTC. Wrapping simply adds additional functionality to your existing asset. You can even look at this as just transferring the funds from one bank account to another. You’re moving it from your BTC wallet to your ETH wallet, which requires it be wrapped. But this is not a disposition of your BTC and therefore is not taxable
Once again, until we get some new legislation from Congress or guidance from the IRS, there are no innately right or wrong answers here. It will depend on your risk tolerance and the specifics of the LP itself.
Earning Interest and Governance Tokens
As a reward for providing liquidity, you’ll be receiving interest and possibly even governance tokens. Both of these are taxable events and need to be counted as income upon receipt. For more information, see our guides on the taxation of crypto interest and airdrops.
Is Exiting a Liquidity Pool Taxable?
Whether or not your exit from an LP constitutes a taxable event will largely depend on which position you took on entry.
Did you treat your receipt of LP tokens as a taxable trade or simply as a swap/depositing collateral?
If you treated it as a trade on entry, it only makes sense to treat your exit the same way. You need to show it as a sale of LP tokens for ETH. In fact, in some cases you’d almost need to from a tax-efficiency standpoint. If you had a capital gain on entry into the LP, there was significant divergent loss, etc. – having a taxable event on your exit from the pool might actually be saving you money.
But if you treated your entry as a loan – and you were counting the receipt of interest/governance tokens as taxable income in real time – then exiting the pool does not generate any taxable event.
Conclusion: Plan With Your CPA and Stay Tuned for IRS Clarification
There are no easy answers when it comes to liquidity pool taxation. Congress has not introduced any legislation and the IRS has not issued any guidance. And unlike other areas of crypto, there is not a clear parallel to some existing area of business or finance.
Take a careful look at the specifics of the project you are depositing liquidity into to determine which approach is the most appropriate for you. Also make sure you’re planning appropriately throughout the year with your CPA – and that you are working with a CPA who is keeping up with these legislative changes.
Any accounting, business, or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.
