So, let\u2019s get started.<\/p>\n
What is Yield Farming?<\/strong><\/h2>\nYield farming allows you to put your crypto to work to earn passive income that would otherwise sit idle in your wallet. So, instead of HODLing your crypto, you can make more with them.<\/p>\n
There are many ways you can put your crypto to work to earn passive income that we\u2019ll discuss in the next section. But on the surface, this is how yield farming works –<\/p>\n
You lend or stake your crypto in a protocol and, in return, receive rewards.<\/p>\n
That\u2019s the simple version. Some people go one step further and deploy much more complex farming strategies to earn the highest returns on their crypto.<\/p>\n
Yield farmers are usually very secretive about the platforms and protocols they’re using to earn returns.<\/p>\n
Why?<\/p>\n
Because the more people join a particular protocol, the less return you earn.<\/p>\n
As you can imagine, finding new and up-and-coming projects to invest your crypto in also exposes you to countless scams and rug pulls.<\/p>\n
Other than that, every platform works differently, resulting in different ways to interpret yield farming taxes.<\/p>\n
How Does Yield Farming Work?<\/strong><\/h2>\n![\"How](\"https:\/\/bitcoin.tax\/blog\/wp-content\/uploads\/2022\/04\/How-Does-Yield-Farming-Work.png\")
<\/p>\n
All the following different methods of yield farming you\u2019re about to see all work with the help of smart contracts – self-executing tasks or contracts set in code.<\/p>\n
AMM (Automated Market Makers) –<\/strong> AMM is what decentralized exchanges<\/a> use to create liquidity to make trading possible.<\/p>\nIt\u2019s pretty simple. You, the liquidity provider, will provide liquidity in pairs of cryptocurrencies in return for a share of the platform\u2019s trading fees.<\/p>\n
Here\u2019s how liquidity pools work.<\/p>\n
Lending Crypto –<\/strong> Lending crypto works the same way traditional loans do. The only difference is there are no third parties involved. You lend your crypto and, in return, receive interest on the loan.<\/p>\nStaking Crypto –<\/strong> You can read all about DeFi staking and how it works<\/a>.<\/p>\nBut on the surface, here\u2019s what you need to know –<\/p>\n
There are two ways to verify transactions in a blockchain – Proof-of-Work (PoS) and Proof-of-Stake (PoS).<\/p>\n
The validating capacity of a PoS-based protocol depends on how much crypto is staked in the network.<\/p>\n
So, you stake your crypto in a PoS protocol, like Ethereum, that helps the network function, and as a reward for your contribution, you receive more crypto.<\/p>\n
These are mainly the three ways you can earn from yield farming. Of course, there are many risks associated with these methods, and we\u2019ll talk more about them later in this article.<\/p>\n
How do you calculate the returns?<\/strong><\/p>\nThe only two ways to calculate returns – APR (Annual Percentage Returns) and APY (Annual Percentage Yield).<\/p>\n
Unfortunately, neither one of these two methods are suitable for finding the true estimates.<\/p>\n
Why?<\/p>\n
Well, because crypto is highly volatile. So, any estimate you calculate with these methods will be inaccurate.<\/p>\n
Maybe, the market was bullish when you estimated the returns, but halfway through, the market drops, and so do your returns, resulting in you losing money. On top of all this, add yield farming taxes, and you may realize that you\u2019re actually losing more than you earn.<\/p>\n
Or the protocol on which you put your crypto in gets crowded, and returns drop significantly.<\/p>\n
Long story short, until a better model for calculating returns comes around, be extremely cautious with your investment decisions.<\/p>\n
Yield Farming Taxes<\/strong><\/h2>\n![\"Yield](\"https:\/\/bitcoin.tax\/blog\/wp-content\/uploads\/2022\/04\/Yield-Farming-Taxes.png\")
<\/p>\n
On the surface, yield farming taxes look pretty straightforward.<\/p>\n
If you receive rewards from staking, lending or providing liquidity to a platform or protocol, you\u2019ll be liable for income taxes.<\/p>\n
On the other hand, if you sell, swap or spend your crypto, you\u2019ll be liable for capital gains taxes.<\/p>\n
The complications start when you realize that every time you\u2019re adding liquidity in a pool or staking your crypto in return for a token representing your contribution, you\u2019re essentially disposing of your crypto, triggering a taxable event.<\/p>\n
So, every time you do that, you\u2019ll incur capital gains (or losses).<\/p>\n
Whether the IRS views this as a taxable event or not isn\u2019t clear, but based on existing guidelines, it seems to be the case.<\/p>\n
At the same time, some platforms allow you to still maintain the ownership of your crypto, despite swapping it for a different token. So, it all depends on the platform and the underlying smart contract.<\/p>\n
Plus, we haven\u2019t even touched on leveraged yield farming, which is a much more complex yielding strategy and results in much more complex yield farming taxes.<\/p>\n
So, if you intend to really do yield farming, consider using Bitcoin.Tax<\/a>, a tax crypto tax calculator. It\u2019ll automatically track all your transactions and income, calculate taxes and create a tax report. It\u2019ll save you a lot of time and effort that you can put into better things.<\/p>\nRisks of Yield Farming<\/strong><\/h2>\n![\"Risks](\"https:\/\/bitcoin.tax\/blog\/wp-content\/uploads\/2022\/04\/Risks-of-Yield-Farming.png\")
<\/p>\n
Scams and Hacks<\/strong><\/h3>\nWe already mentioned how yield farmers are always looking for new and profitable protocols with the highest returns and how it exposes them to thousands of scams and rug pulls happening daily.<\/p>\n
Sometimes, it\u2019s not necessarily a scam that you should be aware of. Some smart contracts have loopholes in them, which hackers can easily exploit. If you put your crypto on a platform that gets hacked, you will lose all your money.<\/p>\n
Mainstream protocols and platforms get popular because first, they were not scams, and second, their underlying smart contracts were good enough to survive hackers for a long time, which is what makes them a good choice for their users.<\/p>\n
But with new protocols, you don\u2019t know that unless you have extensive knowledge and experience in blockchain technology and smart contracts. Otherwise, it\u2019s very unlikely you’ll identify the signs that point to a potential scam or poor coding.<\/p>\n
Volatility<\/strong><\/h3>\nVolatility is a serious issue in yield farming. If the price of the coins you lend or stake dips, you\u2019ll realize an impermanent loss.<\/p>\n
It\u2019s called an impermanent loss because you can wait and endure the losses till the prices go back up and you break even. Or you can choose not to risk further losses and opt-out with a loss.<\/p>\n
Tax Implications<\/strong><\/h3>\nAs we discussed, yield farming taxes can get quite complicated. Other than that, you need to make sure you\u2019re earning enough that it\u2019s worth paying the taxes and the inconvenience of reporting such complex taxes.<\/p>\n
Yield Farming Protocols<\/strong><\/h2>\nThese are some of the most common and popular platforms for yield farming. We talk about some of these platforms extensively in this list of best liquidity pools.<\/p>\n
Uniswap<\/a><\/strong><\/p>\nUniswap is a decentralized platform that allows trading or token swaps without intermediaries or third parties.<\/p>\n
There are many different token pairs and liquidity pools. You can provide liquidity to any one of them to facilitate trades and receive rewards.<\/p>\n
Aave<\/a><\/strong><\/p>\nAave is a crypto lending and borrowing platform. Its biggest USP is flash loans that allow users to take instant, unverified, but small loans without any collateral.<\/p>\n
MakerDAO<\/a><\/strong><\/p>\nMakerDAO allows you to use your crypto as collateral to mint DAI, a stablecoin that you can then use for other yield farming strategies.<\/p>\n
<\/p>\n
All the following different methods of yield farming you\u2019re about to see all work with the help of smart contracts – self-executing tasks or contracts set in code.<\/p>\n
AMM (Automated Market Makers) –<\/strong> AMM is what decentralized exchanges<\/a> use to create liquidity to make trading possible.<\/p>\n It\u2019s pretty simple. You, the liquidity provider, will provide liquidity in pairs of cryptocurrencies in return for a share of the platform\u2019s trading fees.<\/p>\n Here\u2019s how liquidity pools work.<\/p>\n Lending Crypto –<\/strong> Lending crypto works the same way traditional loans do. The only difference is there are no third parties involved. You lend your crypto and, in return, receive interest on the loan.<\/p>\n Staking Crypto –<\/strong> You can read all about DeFi staking and how it works<\/a>.<\/p>\n But on the surface, here\u2019s what you need to know –<\/p>\n There are two ways to verify transactions in a blockchain – Proof-of-Work (PoS) and Proof-of-Stake (PoS).<\/p>\n The validating capacity of a PoS-based protocol depends on how much crypto is staked in the network.<\/p>\n So, you stake your crypto in a PoS protocol, like Ethereum, that helps the network function, and as a reward for your contribution, you receive more crypto.<\/p>\n These are mainly the three ways you can earn from yield farming. Of course, there are many risks associated with these methods, and we\u2019ll talk more about them later in this article.<\/p>\n How do you calculate the returns?<\/strong><\/p>\n The only two ways to calculate returns – APR (Annual Percentage Returns) and APY (Annual Percentage Yield).<\/p>\n Unfortunately, neither one of these two methods are suitable for finding the true estimates.<\/p>\n Why?<\/p>\n Well, because crypto is highly volatile. So, any estimate you calculate with these methods will be inaccurate.<\/p>\n Maybe, the market was bullish when you estimated the returns, but halfway through, the market drops, and so do your returns, resulting in you losing money. On top of all this, add yield farming taxes, and you may realize that you\u2019re actually losing more than you earn.<\/p>\n Or the protocol on which you put your crypto in gets crowded, and returns drop significantly.<\/p>\n Long story short, until a better model for calculating returns comes around, be extremely cautious with your investment decisions.<\/p>\n On the surface, yield farming taxes look pretty straightforward.<\/p>\n If you receive rewards from staking, lending or providing liquidity to a platform or protocol, you\u2019ll be liable for income taxes.<\/p>\n On the other hand, if you sell, swap or spend your crypto, you\u2019ll be liable for capital gains taxes.<\/p>\n The complications start when you realize that every time you\u2019re adding liquidity in a pool or staking your crypto in return for a token representing your contribution, you\u2019re essentially disposing of your crypto, triggering a taxable event.<\/p>\n So, every time you do that, you\u2019ll incur capital gains (or losses).<\/p>\n Whether the IRS views this as a taxable event or not isn\u2019t clear, but based on existing guidelines, it seems to be the case.<\/p>\n At the same time, some platforms allow you to still maintain the ownership of your crypto, despite swapping it for a different token. So, it all depends on the platform and the underlying smart contract.<\/p>\n Plus, we haven\u2019t even touched on leveraged yield farming, which is a much more complex yielding strategy and results in much more complex yield farming taxes.<\/p>\n So, if you intend to really do yield farming, consider using Bitcoin.Tax<\/a>, a tax crypto tax calculator. It\u2019ll automatically track all your transactions and income, calculate taxes and create a tax report. It\u2019ll save you a lot of time and effort that you can put into better things.<\/p>\n We already mentioned how yield farmers are always looking for new and profitable protocols with the highest returns and how it exposes them to thousands of scams and rug pulls happening daily.<\/p>\n Sometimes, it\u2019s not necessarily a scam that you should be aware of. Some smart contracts have loopholes in them, which hackers can easily exploit. If you put your crypto on a platform that gets hacked, you will lose all your money.<\/p>\n Mainstream protocols and platforms get popular because first, they were not scams, and second, their underlying smart contracts were good enough to survive hackers for a long time, which is what makes them a good choice for their users.<\/p>\n But with new protocols, you don\u2019t know that unless you have extensive knowledge and experience in blockchain technology and smart contracts. Otherwise, it\u2019s very unlikely you’ll identify the signs that point to a potential scam or poor coding.<\/p>\n Volatility is a serious issue in yield farming. If the price of the coins you lend or stake dips, you\u2019ll realize an impermanent loss.<\/p>\n It\u2019s called an impermanent loss because you can wait and endure the losses till the prices go back up and you break even. Or you can choose not to risk further losses and opt-out with a loss.<\/p>\n As we discussed, yield farming taxes can get quite complicated. Other than that, you need to make sure you\u2019re earning enough that it\u2019s worth paying the taxes and the inconvenience of reporting such complex taxes.<\/p>\n These are some of the most common and popular platforms for yield farming. We talk about some of these platforms extensively in this list of best liquidity pools.<\/p>\n Uniswap<\/a><\/strong><\/p>\n Uniswap is a decentralized platform that allows trading or token swaps without intermediaries or third parties.<\/p>\n There are many different token pairs and liquidity pools. You can provide liquidity to any one of them to facilitate trades and receive rewards.<\/p>\n Aave<\/a><\/strong><\/p>\n Aave is a crypto lending and borrowing platform. Its biggest USP is flash loans that allow users to take instant, unverified, but small loans without any collateral.<\/p>\n MakerDAO<\/a><\/strong><\/p>\n MakerDAO allows you to use your crypto as collateral to mint DAI, a stablecoin that you can then use for other yield farming strategies.<\/p>\nYield Farming Taxes<\/strong><\/h2>\n
<\/p>\nRisks of Yield Farming<\/strong><\/h2>\n
<\/p>\nScams and Hacks<\/strong><\/h3>\n
Volatility<\/strong><\/h3>\n
Tax Implications<\/strong><\/h3>\n
Yield Farming Protocols<\/strong><\/h2>\n