Decentralized lending and borrowing protocols — Aave, Compound, MakerDAO, and others — allow users to lend crypto and earn interest or borrow against their holdings. The IRS has not issued specific guidance on many DeFi lending transactions, creating a landscape of uncertainty that taxpayers must navigate carefully.

Lending: What We Know

When you deposit crypto into a lending protocol and receive interest payments, the interest is income. This is clear under general tax principles — interest income is ordinary income under §61. The open question is whether depositing the crypto into the lending protocol itself is a taxable event. If depositing is treated as an exchange of your original crypto for a receipt token (like cTokens from Compound), it may trigger a gain or loss at the time of deposit.

Borrowing: Generally Not Taxable

Borrowing is generally not a taxable event because you receive loan proceeds, not income. Using crypto as collateral for a DeFi loan should not trigger a gain or loss — you have not disposed of the collateral. However, if a liquidation occurs — the protocol sells your collateral because the loan-to-value ratio exceeded the threshold — that liquidation is a taxable disposition of your collateral.

Liquidation Events

When your DeFi collateral is liquidated, you have a forced sale. The gain or loss is calculated on the difference between your basis in the liquidated crypto and its fair market value at the time of liquidation. Additionally, liquidation penalties charged by the protocol may or may not be deductible depending on characterization. These events often occur during market crashes — exactly when taxpayers are least prepared to deal with tax consequences.

Receipt Tokens

Many DeFi lending protocols issue receipt tokens (aTokens, cTokens) when you deposit crypto. Whether receiving a receipt token constitutes a taxable exchange of the underlying asset is an unresolved question. Conservative treatment would recognize a taxable event. Aggressive treatment would treat the deposit as a non-taxable transfer similar to depositing cash in a bank. The IRS has not ruled on this specifically.

Navigating Uncertainty

The lack of clear guidance creates risk. Taking a position and documenting your reasoning — then applying it consistently — provides a reasonable basis defense against penalties. Attorney Darrin T. Mish helps crypto investors navigate uncertain tax treatment and resolve any IRS disputes that arise. Free consultation.