Reaping crypto harvests: A beginner's guide to DeFi yield farming

In decentralized finance (DeFi), yield farming is a strategy that offers crypto investors the chance to generate passive income by lending or staking digital assets they already own. The rewards can be lucrative, and multiple platforms provide different opportunities to maximize returns, but there are important tax implications to be aware of. In this guide, we’ll tell you everything you need to know.

Before getting into the details of yield farming, let’s first break down the basics of DeFi:

What is decentralized finance (DeFi)?

The term “DeFi” encompasses a range of peer-to-peer (P2P) financial services that operate on blockchain networks powered by smart contracts. First introduced on the Ethereum platform, smart contracts are programs that automatically trigger specific actions once predetermined conditions are met, making transactions decentralized and trustless. This enables users to lend, borrow, trade, and perform various financial activities without needing traditional intermediaries like banks.

What is yield farming?

Because DeFi protocols operate without centralized institutions, they depend on individual crypto investors to provide liquidity. In other words, investors deposit – or “stake” – their assets in decentralized liquidity pools or lending pools, allowing the platform to function efficiently. In exchange, liquidity providers earn rewards like interest, governance tokens (often used to vote on protocol decisions), or additional cryptocurrency, a process known as "yield farming."

What types of dApps offer crypto farming? 

Several types of dApps offer opportunities for yield farming. Here’s an overview of a few of the most popular:

• Lending and borrowing platforms: dApps like Aave (AAVE) and Compound (COMP) connect crypto borrowers with lenders. Yield farmers contribute their crypto to these platforms and earn interest from borrowers.
• Decentralized exchanges (DEXs): Unlike centralized exchanges (CEXs), DEXs use automated models (AMMs) to facilitate P2P trades. Yield farmers supply token pairs to liquidity pools on platforms like Uniswap (UNI) or Sushi (SUSHI) and collect fees with each trade.
• Staking platforms: On proof-of-stake (PoS) blockchains, stakers “lock up” their assets to help secure the network. Yield farmers can stake directly on platforms like Lido Finance, which also offers "liquid staking," where stakers receive synthetic tokens representing their staked assets that they can restake or reinvest elsewhere to further optimize returns without sacrificing liquidity.

Liquidity mining vs. yield farming

Liquidity mining and yield farming are often confused because both involve earning rewards through DeFi activities. However, liquidity mining specifically refers to locking cryptocurrencies into liquidity pools to earn a protocol’s proprietary tokens, often called "mining" these tokens. In contrast, yield farming encompasses a broader range of strategies, including earning interest, staking, and other mechanisms, to maximize returns on digital assets. Liquidity mining focuses on earning governance or incentive tokens, while yield farming encompasses a range of strategies to maximize returns on digital assets through interest, staking, and other mechanisms.

DeFi and taxes

Tax authorities worldwide are still adapting to DeFi, but many, such as the Internal Revenue Service, already impose tax obligations on gains earned through strategies such as yield farming. Here’s a brief look at common DeFi activities, including yield farming, and their potential tax implications:

• Crypto lending: Interest earned from P2P loans is typically considered taxable income, though it may be possible to claim a deduction if a borrower defaults on the loan.
• Crypto borrowing: Taking out a crypto loan generally doesn’t trigger tax obligations unless it’s treated as a taxable exchange; interest payments on a loan may be deductible if used for business purposes.
• Earning interest in DeFi: Yield farming rewards, like interest and governance tokens, count as taxable income. To ensure proper tax reporting, it’s important to track earnings accurately. Tools like CoinTracker simplify the process by automatically recording transactions, categorizing rewards, and syncing with wallets and exchanges, helping traders stay compliant with tax regulations while minimizing the hassle of manual calculations.
• Liquidity mining for governance tokens: When governance tokens are earned through liquidity mining, their fair market value at the time of acquisition is considered taxable income. Selling these tokens incurs capital gains or losses based on the sale price versus the acquisition cost.
• Liquidation on a crypto loan: Depending on the type of investment and applicable tax laws, investors who lose collateral through liquidation may be eligible for a tax deduction.
• Exiting liquidity pools: When exiting a liquidity pool, users may face a taxable event if they receive assets different from their original deposit. Additionally, any changes in the value of staked assets while in the pool can result in capital gains or losses, which must be reported like other taxable transactions. 
• Transaction fees: Although many tax authorities have not provided explicit guidance on the deductibility of gas fees, they may be deductible in some circumstances, such as those spent for business-related DeFi transactions or fees required to purchase or sell an asset.

Six of the best yield farming platforms to consider

Yield farmers often use aggregator websites like DeFi Llama to find lucrative opportunities for deploying crypto collateral. New platforms are always emerging, but these well-established DeFi dApps stand out for their security, reliability, and innovative features: 

Compound

Compound (COMP) is a pioneering DeFi lending protocol built on the Ethereum blockchain, launched in 2017. Users can lend their digital assets to earn interest or borrow from liquidity pools. Compound was among the first platforms to introduce liquidity mining, rewarding users with its native COMP governance token. It also integrates with Ethereum’s layer 2 solutions like Arbitrum (ARB) and Optimism (OP), which help reduce transaction costs and improve processing speed.

Uniswap

Launched in 2018, Uniswap (UNI) revolutionized decentralized exchanges by introducing an automated market maker (AMM) model. Yield farmers provide liquidity to Uniswap’s token pairs, earning a share of trading fees and additional UNI tokens through liquidity mining. Its 50/50 liquidity pools and, more recently, concentrated liquidity pools allow users to swap tokens directly from self-custodial wallets while maintaining decentralized control.

Curve

Curve Finance (CRV) is designed specifically for low-volatility trading pairs such as stablecoins and wrapped tokens. This makes it a popular choice for yield farmers seeking more predictable returns. By providing liquidity, users earn trading fees and CRV governance tokens, which can also be staked for additional rewards, reducing exposure to impermanent loss common on other platforms.

Aave

Aave (AAVE) offers features similar to Compound but with additional innovations like flash loans and the GHO stablecoin. Yield farmers can lend their crypto in exchange for interest and earn AAVE tokens through liquidity mining. Aave also offers staking in its Safety Module, which helps secure the platform and rewards participants with additional AAVE tokens.

MakerDAO

MakerDAO (MKR), now rebranded to Sky,  is the decentralized backbone of the DAI stablecoin, now rebranded to USDS, which maintains its value relative to the U.S. dollar. Borrowers can generate DAI by locking crypto collateral in a Maker Vault, while yield farmers earn interest and MKR tokens as borrowers repay their loans. MKR holders also govern the platform, deciding on critical factors like accepted collateral types and interest rates.

Yearn

Yearn (YRN) is a DeFi yield aggregator that searches for the highest interest rates across multiple protocols and automatically reallocates funds to maximize returns. Designed for investors seeking a more passive strategy, Yearn’s "Vaults" system simplifies yield farming by pooling funds and strategically reallocating them across various dApps for optimal returns.

Keep tabs on DeFi yield farming with CoinTracker 

Yield farming can be profitable, but failing to accurately report yield farming activities can lead to compliance issues or tax overpayments. CoinTracker simplifies this process by seamlessly integrating with hundreds of wallets, exchanges, and DeFi smart contracts, automatically calculating your web3 income and eliminating the need for manual reporting. Its automatic categorization of DeFi transactions saves time and reduces the hassle of preparing tax forms.

CoinTracker also prioritizes security and compliance, ensuring that users’ data is protected and aligned with current tax regulations. Get started for free and join millions of traders who trust CoinTracker for effortless crypto tax reporting.

Disclaimer: This post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.