How Is Crypto Taxed? DeFi & NFTs

When it comes to decentralised finance, which is our next topic we’re talking about DeFi.

It’s a brand new evolving space for cryptocurrency. Quite exciting. I know I know a lot of people getting involved. But I do also like to kick off the topic and mention that it can be an absolute accounting nightmare.

So it’s very important that we look into this and wrap our head around what’s going on here and appreciate the complexity of the accounting that needs to be done here. And hopefully for yourself, arrange your affairs so that those complexities are minimised as much as possible.

So I suppose I’d like to really kick off immediately by saying that there can be unexpected disposal events when it comes to DeFi.

So DeFi, so in the traditional sense of just doing trades on a decentralised exchange, which typically mostly done at this stage on the Ethereum blockchain. You’re doing them and you’re switching crypto on the exchange. Okay, directly. Direct (direct) exchange of say Uniswap token for wrapped Ether token. And it’s all done on a decentralised exchange.

As we’ve already gone through earlier on in the course that is the crypto transaction. Yeah, so we’re all settled on that. We’re all happy. We know about that. From an accounting point of view. Perhaps a little bit harder to get that, that data, compared to if it was done on a centralised exchange because the centralised exchange, bang, got the transaction history there available. But it is available from a decentralised point of view at least here it will say, Uniswap transaction, it mostly should be available connected to that Ethereum address, as we’ve already gone through in the record keeping part of the course, and you should be able to paste your Ethereum address into one of those softwares and it should pull through those transactions. So, at that point, we’re reasonably comfortable that we can get the data. A little bit harder, but we can get the data.

Some unexpected disposal events can be mostly around when you might be trying to earn, let’s say, some interest or possibly have some borrowings on crypto.

So what happens in decentralised land, as I like to call it, is that people can, for lack of a better term, lock up their crypto or stake their crypto, some of the times called various different names for all this stuff. But I can put say some Ether onto one of these DeFi platforms and I can begin to earn some interest. Okay. Whether it be more Ether or it might be in a different coin, let’s say, let’s just say it’s called Aave Coin, for example.

It’s all meant to be decentralised as in, I don’t have necessarily counterparty risks. It’s not. There’s not a middle person in between here. There’s me, I’m lending my Ether out and there’s a peer to peer transaction. Someone else on the other side taking my Ether and then paying me in some interest, some other crypto in here. But the act of me putting my Ether into this platform is most likely a disposal event.

You might be going but I’ve just put my Ether there. It’s locked up in a smart contract and I’m going to get that Ether back. Now the thing here, the key reason why there’s most likely a disposal event, is if you’re earning interest from this crypto that you’ve locked up you’ve got to think why are people paying you interest, and (what) what’s their incentive?

The most likely, uh, circumstances here is that other party has now taken off that Ether or possibly they’ve got some other crypto, but let’s just say for this first scenario, they take it off with that Ether and then they’ve gone ahead and perhaps they’re now trading with it. They’re using it for whatever purpose they need to, we don’t necessarily need to care. We just know that they’ve taken off with the Ether, now they’re paying you some interest.

Now the fact that you no longer have control of that Ether and someone else has taken off with it, and because they’ve taken off with it, when they put some Ether back in there and when you take it out, it’s highly likely you’re going to get a different Ether back; different token.

So, we go all the way back to the basics part of this course, when we were talking about disposal events, we were talking about the fact that it all comes down to do you still own that same asset.

So, in this example here, the most likely scenario was that most likely disposal event, even though it’s unexpected because you think your Ether is locked up, is that you no longer are getting the same Ether token back, because it’s a different token. And in that period when you had it in the smart contract locked up and away; it’s no longer under your control or ownership, and this has most likely been a disposal event. So that can come up and be quite unexpected and can have such quite severe tax outcomes.

Touch on those in a second.

Sort of another way where there can be a disposal event, because it’s not necessarily that a person’s taken away with Ether. What can happen is that you might put your Ether into one of these decentralised marketplaces to earn interest. And when you put it in, rather than necessarily be just locked up by itself, it gets locked up in a pool, sometimes called “liquidity pools” in these decentralised platforms.

And, so it’s pulled together with everyone else and you get back a token sometimes called, very similar, so it might be instead of ETH token, say we’ve got, ah, Drew’s decentralised world and I call my tokens DETH. Okay. You get back a DETH token. This token, now, sometimes some people call it, it’s a placeholder token, and that, or it (it) represents the ETH I put in there, which it does, but it is actually a different asset because it’s actually representing your share of a pool of Ether.

Okay. So when you go and exchange that, that token back to get your Ether, you aren’t necessarily getting the exact same Ether back. You might be getting the same quantity back. It’s, well hope and, hopefully some interest along the way, but a different token. So what’s happened here is once again, when you put Ether into the pool, because now it’s wrapped up with everyone else’s and you’re getting some other asset back, just slightly different asset, you’ve now had a disposal event.

So hence the unexpected disposal.

So, the unexpected disposal has a reasonably big tax consequence for yourself. Because your otherwise, you’re thinking, Hey, I haven’t had any disposal yet. It’s an unrealised, I might be sitting on an unrealised profit at this time. And by this time that you’re doing this, you might’ve bought Ether way back when it was really cheap. Now it’s, it’s gone through a boom. It’s really high in value. And all of a sudden you’ve got a disposal event that you didn’t otherwise know of. So you’ve turned an unrealised profit into a realised profit. Huge consequences.

Now you’ve got gains report. Hopefully you can still get the CGT discount if you held it for more than 12 months. But it’s happened at that time.

And not only does it happen at that time, but when you go and you take your Ether back out, boom, another event’s happened.

Because in the meantime, you’ve held a different asset. You’ve either held that replacement asset, that placeholder asset, that DETH that I used in the example earlier, you put that in, and then you take out your ETH. Now you’ve had a disposal of your DETH, your ETH. Could have had a gain or a loss there, depending on the fluctuation of the value of ETH during that time. So what I’m saying is, within that pool, if ETH had appreciated any value from going in to coming out by the time you take it out the tax world is going hey, the value of it at the time coming out, that’s your proceeds. The cost was when you put it in there, the value then. So the uplift in value is all of a sudden, that’s a further gain that you’ve got to report. If that’s all happened, going into the pool, coming out within a 12 month period, no CGT discount on that next part.

So huge implications there. A lot to wrap our heads around. A lot of accounting work to do, hence the complexity of this world. Please do appreciate that.

I can’t make a blanket rule on this, in terms of the decentralised world.

There’s all different platforms, all different ways of doing this thing. That’s the part of the, sort of excitement, of this world. All the innovation is going on and every platform does things slightly different way. So there’s no blanket rule on this.

So what you have to do is, as advisors, clients come to us, they ask us what about the Aave platform, what about Synthetix over here, all these different platforms that are out there we have to look at each individual one, and work out, okay, event A, B, C, and D are happening over here, or event A and B are happening over here . Basically, it’s, if you’re getting in this world, if you’re not doing huge sums of money, and the sort of the burden from accounting point of view can play a huge heavy role on you.

I think you need to take that into consideration. And if you are playing, playing around, maybe not playing around, investing, with large sums of money it all of a sudden becomes a huge tax sort of obligation, liability there possibly because you might be triggering gains, making profits you otherwise weren’t aware of.

So please take that into consideration.

So as part of this world, we put our crypto in there, we’re trying to earn interest, and earns extra crypto, which are sometimes called interest, sometimes called staking, and in this case, slightly different proof of stake, which we’ll touch on in another topic of this online course. But the decentralised world, for the sake of argument we call that, that’s most of the time pretty similar to your earning interest in a bank.

Look, if you’ve put something, if you’ve gone ahead and done something, so you put some crypto over there and now you’re earning some interest back. Yeah. The value of the coins as they come in are income.

So you have to do your accounting. Yeah. Okay. On day one you earned $1 worth of crypto at that time. On day two, the crypto I got was $1. On day three, hey, now the cryptos a $1.10. On day four, whew, prices spiked, I’ve got $2 worth of crypto on that day. Each one of those events, that’s income to report, to go into the tax return, the relevant tax return for that period. And that cost, the cost for those crypto, it’s whatever the value was at the time they were received.

Now I do know that there are some platforms out there, they don’t actually pay interest in this way. Rather than actually giving you more crypto as you go along or more interest, what they do is, behind the scenes, the coin that you received when you put it into, say, one of these pools, it’s actually meant to appreciate in value. Okay, so you don’t actually receive more of these coins. The coin itself is meant to, because of all the mechanisms behind the scenes, appreciate in value over time. So what this means is because you’re now not receiving more coins, you’ve just got the same coin there and it’s appreciating value, you don’t actually have interest to report.

Because you’re not receiving anything extra, you just have your ordinary outcomes. So if you’re a speculated/investor and that coin appreciates by the time you dispose of it, now you just have a gain or a loss.

If you’re in business world, profit making world, so the revenue account that we spoke about earlier in the course, in that world, you’ve got a profit or loss to report. It’s treated as your trading stock in most cases.

So that’s a, once again, the little differences in the platforms can have a little different outcomes. You really need to look into what’s happening. That’s where it’s a little bit difficult. Once again, because of all the little mechanics behind the scenes and how each platform works as to what the exact outcome is.

Okay, so there’s also mechanisms within decentralised world to borrow against your crypto.

Okay, so I can get my say I’ve got, I was lucky enough, bought some ETH back in the day. My ETH is now worth, let’s say it’s worth $500,000, Drew’s very happy with $500,000 of ETH. But being a tax savvy here, I’m like, phew, if I go sell some of this ETH then I’m going to have to pay tax on the gain. And I’m a bit of a speculator at the moment, I’m thinking, hey, it’s still got a while to go. I also want to keep some in my mouth and have exposure to the appreciation of the value, hopefully. And rather than selling it, but I still want the money because I want to go and buy a house, for example.

But, what we can do now, there are platforms out there that enable me to borrow against my ETH. So it depends on, this is once again, same as all the other platforms that I was speaking about, they will do it slightly differently. So it may or may not eventuate in a disposal.

I suppose here I need to be very careful because part of the reason why I’m doing the borrowing is because I don’t want to have a disposal event.

So I can put my ETH on some of these platforms. And it’s there as collateral. So collateral means it’s just locked up. It’s like when I buy a house and I get a loan from the bank, and the bank takes a mortgage over my house.

So if something goes wrong, boom, they got access to the house. That’s what we’re talking about here with crypto. Put it over here. It’s held there as collateral, but it’s still mine. I still own it, still hold it. Just for the moment, it’s just locked up and certain things happen. Like I don’t pay off the loan, the smart contract is going to go, all right we’re going to sell some of this ETH to pay off Drew’s loan, so that the the lender is covered. That’s the general mechanics of what’s meant to be happening.

But, so, as long as it’s held there and hasn’t been used to repay the loan I’ve been paying off, uh, according to the obligations; the repayment obligations; it’s still held there, still mine, there hasn’t been a disposal event. I take the money and I go buy the house, that’s all good.

But some of these platforms don’t necessarily work like that.

And the trick here is though, that some of these platforms might even just say, they might even say the right things.

Like they might say, yeah, Drew, you can put your ETH over there and it’s held as “collateral”.

They might say that, but then when you dive deeper into these platforms, the terms and conditions, which are sometimes they’re really hard to find.

But once you dive into there and you read the terms and conditions and you work out what’s going on, you’d be surprised to see that sometimes they actually say, nah Drew, although we might say it’s held as collateral, you’ve actually had an outright disposal of (of) your ETH, crypto, any crypto whatever’s, was involved in this, and we just owe you this crypto back later on.

So if that is the case, then I have had a disposal again, and I have got those tax obligations on my ETH and the disposal and the paper gain here.

So huge different outcome there.

Very tricky of some of these platforms to call it collateral when it’s not actually collateral, when you dive in to look at terms conditions and see that it’s been an actual disposal.

So gotta be very mindful of that and I would suggest that if you are looking at doing any of this, that you do seek out tailored tax advice to make sure you know the implications of your activities. Yeah, especially since it can be unexpected.

So a lot of what I’ve just spoke about there applies very much in the CeFi world, centralised finance world which is, there’s platforms rather than being decentralised with meant to remove the middle, middle party. No, there is a middle person there. Middle entity. And, if I’m putting crypto in an interest account or I’m borrowing, very similar outcomes can be had there. A lot of times that these things aren’t disposable events.

So just be mindful of that.

And I suppose, the other thing I want to speak about here, which isn’t 100% always just DeFi, but it’s related to the space and the evolving innovations and stuff is NFTs.

Non fungible tokens that are out there.

Simply put, look, if you’re investing, if you’re speculating in this, if you’re hoping prices to go up in value, similar tax outcomes as we spoke about throughout this course. You bought something, that’s the acquisition, when you dispose of it, that has appreciating value, in Australian dollar terms, and you’ve got a gain there, and then you’ve got to look back, okay, how long did you hold that for and if it’s more than 12 months, it may be that you get the CGT discount after applying your losses.

So that’s important. I know that some of these NFTs are connected to things like games and then at times we get asked, because it’s a game, is it tax free? Which is going back to the personal use case, and the personal use exemptions spoken about earlier in this course. Ultimately, much like I mentioned in that segment, it’s around, is it actual genuine personal use?

So if you’re playing a game, don’t care whatsoever about the appreciation of the asset. You’re just playing the game and you just happen to get NFTs throughout playing that game, then most likely don’t have to worry about the tax because it’s just personal use of the game. But if you are, to some extent, playing that game and you know that by playing the game you get NFTs and they can go up in value and you plan to actually, you’re doing it for the reason of getting the NFTs and hoping they go up in value, then it’s going to be a taxable event