A liquidity pool is a crowdsourced pool of cryptocurrencies or tokens locked in a smart contract that is used to facilitate trades between the assets on a decentralized exchange (DEX) providing liquidity and convenience to the DeFi ecosystem.
When a user supplies a pool with liquidity, they are often rewarded with Liquidity Provider (LP) tokens in proportion to the amount of liquidity. When the pool facilitates a trade a fractional fee is distributed proportionally amongst the LP token holders.
Liquidity Pool Rewards
There has been no official guidance on liquidity pools from the IRS and as such we recommend that you speak with your tax attorney or accountant about the best way to file your return.
Earning liquidity tokens from DeFi protocols
Generally if you are receiving new tokens from contributing to a liquidity pool, this should be recorded as income. If you are increasing the value of an existing asset that you continue to hold, then you should report this as a capital gain.
Adding or removing tokens from a liquidity pool
There are two ways to consider adding or removing a token from a pool.
An aggressive stance would be to say that depositing a token in a pool is just that - a deposit. The LP token that you receive in this instance would be considered a 'receipt' or note proving your deposit. In this case, there would be no taxable event.
A more conservative position would be to consider this a crypto-crypto trade - the crypto you deposit is essentially given to the pool and you are instead receiving a new token in exchange. Using this methodology would result in a capital gain or loss and the associated taxes.
How to report: The safest option is to report these transactions as exchanges that result in a capital gain or loss. As this is an emerging area of crypto-taxes we highly recommend that you consult your CPA about the best way to file.