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.
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.
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.