DeFi Lending Taxes: Aave, Compound, and Yield Farming
How DeFi lending and yield farming are taxed. Covers Aave and Compound deposits, interest income, liquidations, receipt tokens (aTokens, cTokens), and impermanent loss.
DeFi Lending: More Complex Than It Looks
Lending on Aave, Compound, and similar protocols looks simple: you deposit tokens, earn interest, and withdraw later. But from a tax perspective, almost every step of this process is contested territory. The IRS hasn't issued specific guidance on DeFi lending as of 2026, leaving practitioners to apply general property rules — and reasonable people can disagree on how those rules apply.
This guide covers the conservative (IRS-favored) positions as well as the aggressive positions, so you can make an informed decision with your tax advisor.
Depositing Into Aave or Compound
When you deposit tokens into Aave, you receive aTokens in return (e.g., deposit DAI, receive aDAI). On Compound, you receive cTokens (deposit USDC, receive cUSDC). These receipt tokens represent your deposit plus accrued interest.
Conservative position (our default): taxable swap
Depositing tokens and receiving receipt tokens is treated as a taxable disposal of your deposit tokens at current FMV. You receive aTokens/cTokens with a cost basis equal to the FMV of what you deposited. This triggers a capital gain or loss on the deposit tokens.
Aggressive position: non-taxable deposit
Some tax professionals argue that depositing into a lending pool is analogous to depositing cash at a bank — a loan, not a sale. Under this view, no taxable event occurs at deposit; you're simply holding a different representation of the same economic value.
Without explicit IRS guidance, the conservative position (taxable) is safer from an audit perspective. Blockchain Smart Tax defaults to the conservative treatment but allows you to override individual transactions if you work with an advisor who recommends the aggressive position.
Interest Income From Lending
Interest earned from Aave/Compound deposits is taxable as ordinary income — this is not disputed. The question is when:
- aTokens (Aave): Your aToken balance grows continuously with each block. The IRS's constructive receipt doctrine suggests this accruing interest is income as it accrues, not just when you withdraw. However, tracking per-block accruals is impractical. Most practitioners treat it as income when you withdraw or when you receive it in a claimable form.
- cTokens (Compound): Your cToken balance doesn't change — but each cToken becomes worth more of the underlying over time. The appreciation is generally treated as income when you redeem (not as it accrues), similar to zero-coupon bonds, though this too is unsettled.
The value of interest included in income becomes your cost basis for the received tokens, preventing double-taxation when you eventually sell.
Liquidation Events
DeFi lending allows borrowing against collateral. If your collateral value drops too low (below the liquidation threshold), your position is automatically liquidated — a liquidator repays your debt and receives your collateral at a discount.
Liquidation is a taxable event. The IRS treats it as a forced sale of your collateral:
- Proceeds = the amount of debt cleared by the liquidation (FMV of collateral used to repay the loan)
- Cost basis = your original cost basis in the liquidated collateral
- Gain/loss = proceeds minus cost basis
The liquidation penalty (the discount the liquidator receives) is an economic loss but not a separate tax deduction — it's already reflected in the lower proceeds you effectively received.
Yield Farming and Liquidity Mining
Many DeFi protocols distribute governance tokens (COMP, AAVE, CRV, BAL, etc.) as rewards for providing liquidity or borrowing. These reward tokens are taxable as ordinary income when received, at their FMV at the time of receipt.
This creates a potentially frustrating situation: you earn COMP rewards worth $1,000, pay income tax on $1,000, then the price of COMP falls. You've paid tax on income you no longer have the full economic benefit of. This is a feature (not a bug) of how the tax system treats ordinary income.
Strategies to manage yield farming taxes:
- Harvest rewards at strategic times — multiple small harvests create many income events; fewer larger harvests may simplify reporting
- Consider whether to sell reward tokens immediately (while you have cash to pay the tax) vs. hold and risk a subsequent price decline
- Track your cost basis in reward tokens carefully — future sales trigger capital gains/losses above/below the income inclusion amount
Impermanent Loss
When you provide liquidity to an AMM pool (Uniswap, Curve, etc.), impermanent loss occurs when the price ratio of the two tokens changes. You end up with less total value than if you'd simply held both tokens.
As discussed in our DeFi tax guide, impermanent loss is not a separate tax deduction. It's an economic loss embedded in the lower value of your LP position when you exit. The capital loss is captured when you exit the LP position — you just don't get an additional IL deduction on top of that.
Track DeFi Lending Taxes Automatically
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