Yield Farming and Liquidity Pool Taxes Explained

A general DeFi guide will tell you that swaps are disposals and rewards are income. Both are true and neither answers what actually happens when you deposit two assets into a pool, receive a token representing your share, watch the ratio drift, and withdraw something different from what you put in.

This guide covers the parts a general guide skips.

Reward tokens: the settled part

Crypto you earn is ordinary income at its fair market value on the day you receive it. Reward tokens from a farm are earned crypto. The value at receipt is income, and it becomes your cost basis in those tokens, so the later sale is a separate capital gain or loss measured against it.

The difficulty is volume rather than principle. Rewards accruing per block produce a very large number of income events, each needing a value at its own timestamp. This is the single strongest practical reason DeFi users need software rather than a spreadsheet.

A related question is when a reward is received. Tokens that accrue continuously but must be claimed raise the question of whether receipt is accrual or claim. Pick a defensible answer, apply it consistently, and record enough to support either.

Entering a pool: the unsettled part

You deposit two assets and receive an LP token. Is that a disposal of the deposited assets in exchange for a new asset, or a deposit that leaves your ownership intact?

Both characterisations are argued. Treating it as a disposal produces gain or loss at entry and gives the LP token a fresh basis. Treating it as a deposit defers everything to exit. The IRS has not resolved this specifically, and the honest position is that you are taking a position rather than following a rule.

What is not defensible is switching between the two depending on which is cheaper in a given year. Consistency is what makes a position survivable.

Exiting a pool

The same characterisation question runs in reverse, and it compounds, because what you withdraw is usually not what you deposited. Impermanent loss is real economics: the pool rebalances against you, so you come out with more of the asset that fell and less of the one that rose.

Impermanent loss is not a deductible loss

This catches people every year. Impermanent loss is a change in the composition and value of your position while you hold it. Unrealised movements are not deductible. What is realised, and therefore what has tax consequences, is what happens on exit, measured against the basis of what you are treated as disposing of.

So the answer is not that impermanent loss is ignored, it is that it shows up through the exit computation rather than as a separate loss line.

Auto compounding vaults

A vault that harvests and reinvests rewards on your behalf is doing something on your behalf. If the underlying harvest is income to you, an auto compounding wrapper does not make it not income, it makes it invisible in your wallet history. Vault positions frequently need the protocol's own accounting data to reconstruct, because the wallet only sees a share token whose value drifts upward.

Where the US rules still frame everything

• Short term gains are taxed at ordinary rates up to 37%; long term at 0%, 15% or 20%.
• Losses offset gains, with up to 3,000 dollars of net loss usable against ordinary income each year and the rest carried forward.
• Cost basis is tracked per wallet or account under Revenue Procedure 2024-28, which matters for DeFi because positions naturally sprawl across wallets.
• Gas fees paid on a disposal are part of the cost of that disposal. Gas on non taxable actions is a harder question and should be treated consistently.

Our DeFi tax guide covers the broader protocol landscape, and US crypto tax covers the rates and forms.

General information, not tax advice. Rules change and depend on your circumstances. Confirm the current position with the relevant tax authority or a qualified tax professional.