Understanding Taxes on Yield Farming Rewards

Disclaimer: This article is for educational purposes only. It does not constitute tax or financial advice. Always consult with a licensed professional before making decisions on your tax filings.

This guide is part of the “Guide to Yield Farming” series.

Yield farming has become one of the most talked-about strategies in decentralized finance. It offers traders a way to passively earn rewards that can sometimes exceed other traditional banking products and even stock dividends. 

This is how it works: you put your crypto in lending pools, liquidity markets, or protocols, and in return, you receive extra tokens. The reality of taxes is much more complicated, especially in the United States, where every transaction carries tax consequences under the new IRS rules. 

Every time you earn tokens, swap assets, or move liquidity, the IRS sees it as a taxable event. That means earning those high yields will come with some obligations. The difficulty is that the US tax code was built before decentralized protocols were invented. Farmers might be completing hundreds or even thousands of transactions in a single year, each one creating a new line item for their tax returns.

The IRS made its position clear, cryptocurrency is property, not currency. That classification means both income tax and capital gains rules apply to farming taxes. But the exact tax implications for complex DeFi activities are still being written. Some areas are black and white, others are grey, but the burden of proof falls on you and I, the taxpayers.

This guide is written for crypto traders who want clarity. It explains how yield farming is taxed in the United States, which activities count as taxable, how to calculate obligations, and how to report them correctly. It also highlights common mistakes, gives some strategies for tax-loss harvesting, and goes over the areas where tax guidance remains unclear.

This article is for educational purposes only. It does not constitute legal, financial, or tax advice. Always seek advice from a licensed tax professional before making decisions that can affect your taxes.

Are yield farming rewards taxable in the US?

The short answer is yes. Farming rewards are taxable. Under the current laws, when you receive new tokens as a reward for farming your assets, or staking in a DeFi protocol, you must report them as ordinary income at their fair market value when you get them.

This rule is established in IRS Notice 2014-21, which classified digital assets as property. That single decision forms the foundation of all cryptocurrency tax law in the US today. It means crypto does not qualify for foreign currency treatment. Instead, it is treated more like a stock or piece of real estate. When you acquire it, you have a basis. When you sell or swap it, you may generate capital gains.

For yield farmers, this creates a two-step tax process. First, farming rewards are taxed as income the moment they are received. Second, any future sale, swap, or disposal of those tokens is subject to capital gains tax.

Consider this example. You farm a new token and receive 50 units worth 20$ each at the time of receipt. That is 1,000$ of ordinary income that must be reported. If you later sell them for 1,200$, you also have a capital gain of 200$. If you sell for 800$ instead, you report a 200$ capital loss.

The IRS expects both types of events to appear in your tax forms. Income is reported on Schedule 1 of Form 1040, while capital gains are reported on Form 8949 in Schedule D. If you fail to disclose either, you risk underreporting, in which case you will face fines, interest charges, or other legal penalties.

The key principle here is when new tokens enter your wallet and have measurable value, they are taxable as income. Later, when you dispose of them, you must account for gains based on the difference between your basis and the disposal proceeds.

Identifying taxable events in the yield farming lifecycle

Yield farming is not a single action but a chain of activities. Each can carry its own tax consequences. Let’s map out the lifecycle and highlight the tax obligations of each step.

Event 1: Earning and claiming farming rewards

The moment you claim tokens from a pool, vault, or protocol, they are treated as ordinary income. The IRS wants you to record the fair market value in US dollars at that exact point. That number becomes your cost basis for future disposals.

Some protocols even auto-compound rewards before you can claim them. Does that count as income at each compounding step? The tax guidance says income arises when you have control, which usually happens when tokens appear in your wallet, not when they remain locked up in a smart contract.

Event 2: Selling, swapping, or spending rewards

Once you own tokens, any disposal is a capital gains event. Disposal includes selling for fiat, trading for another cryptocurrency, or spending them. The gain or loss is the difference between your cost basis and the disposal price.

Your holding period matters:

• Less than one year = short-term capital gains, taxed at the same rate as income.
  • 10%, 12%, 22%, 24%, 32%, 35%, 37%, depends on your taxable income bracket.
• More than one year = long-term capital gains, taxed at preferential rates, which are:
  • 0%, 15%, or 20%, depending on your taxable income level.

Because most farmers recycle tokens quickly (moving them between vaults, pools, and different strategies), the majority of gains are realized in under a year, so they fall into short-term capital gains and are taxed just like ordinary income.

Event 3: Adding or removing liquidity

Liquidity provision creates some of the most complex tax implications. When you deposit tokens into a pool, you typically exchange them for LP tokens. Many experts believe this counts as disposing of your original tokens and acquiring new property. That means potential capital gains at the moment of deposit.

The same applies when withdrawing liquidity. Redeeming LP tokens for the underlying assets counts as a taxable disposal of the LP tokens. Any difference in value is a gain or loss.

This area is unsettled. Some argue LP tokens are simply a representation of your existing property, not a new asset. Until the IRS provides us with clear tax guidance on this term, the conservative stance would be to treat both adding and removing liquidity as taxable events.

Event 4: Compounding and reinvestment strategies

Auto-compounding vaults create a tax grey area. When rewards are harvested and reinvested automatically, you don’t directly control the funds during each cycle. Some experts argue that means no taxable event occurs until you withdraw. 

Others take the conservative view that every reinvestment should be treated as income. The IRS has not issued clear tax guidance yet, so most farmers rely on tax professionals or software to handle these cases cautiously.

Event 5: Governance tokens, restaking, and edge cases

Many protocols don’t just pay out one reward. They may issue governance tokens, secondary incentives, or rewards that you don’t get all at once (vested). Each type has to be reported as a separate line item for tax purposes. If rewards are vested but you cannot access them yet, they usually are not taxable until you gain control.

Complications grow when you re-stake or lend those rewards into new protocols. Each move can create a new taxable event, whether as income or capital gains. 

How to calculate and report yield farming taxes (US)

Because yield farming creates such a dense web of transactions, accurate calculation is hard to do. But because it’s so important, here are step-by-step instructions.

Step 1: Keep meticulous records

For each transaction, you need to document:

• Date and time
• Transaction type (claim, swap, liquidity add/remove)
• Asset type and quantity
• Fair market value in USD
• Wallet address or transaction hash

Without this, you cannot prove your basis or calculate gains tax correctly.

Step 2: Use a tax calculator or crypto tax software

Manual tracking is nearly impossible for active farmers. Tools like Koinly, CoinTracker, and Accointing integrate with wallets and exchanges to automatically import DeFi transactions and generate reports. 

The best part is that these platforms can prepare your cryptocurrency tax summaries, fill out Form 8949, and integrate with TurboTax or CPA systems.

Step 3: Differentiate income vs capital gains

When you first receive farming rewards, the IRS treats them as ordinary income. You must report the fair market value in dollars on the date you received them, and that amount is subject to income tax at your regular tax rates.

Later, when you sell, swap, or spend those same tokens, the event is treated differently. It creates a capital gains tax obligation (or a capital loss if the value dropped). The gain or loss is simply the difference between what the tokens were worth when you got them (your cost basis) and what they are worth when you dispose of them.

Because income tax and capital gains tax are reported on different tax forms, they must be tracked separately. Think of it as two layers: the first layer is income when tokens arrive, the second layer is capital gain or loss when tokens leave.

Step 4: Report on the correct tax forms

• Ordinary income from farming rewards is entered on Form 1040, Schedule 1. That is the same place you would report freelance income or side business revenue.
• Capital gains and losses from later selling or swapping those rewards belong on Form 8949 and go into Schedule D.
• On top of that, the IRS now asks a yes-or-no question on the front page of Form 1040: did you at any time receive, sell, or otherwise dispose of digital assets? If you have done any yield farming, the answer is almost always yes.

With this workflow, a farmer can produce a tax return that aligns with the IRS expectations.

Most common mistakes to avoid

Even experienced investors often make errors when handling farming taxes. Here are the most damaging ones.

• Ignoring small rewards. Even dust-level tokens count as income. IRS audits do not ignore them.
• Double-counting. Some taxpayers mistakenly count farming rewards as both income and capital gains at receipt. They are income first, gains only at disposal.
• Forgetting liquidity pool events. Adding and removing liquidity often go unreported, but they may trigger taxable events and problems if you fail to report them.
• No fair market value records. If you don’t record the FMV at the time of receipt, cost basis calculations become impossible.
• Assuming anonymity. Believing crypto is untraceable is a myth. The IRS has increased blockchain surveillance and has been steadily issuing summons to major exchanges and even DeFi platforms.

Tax-loss harvesting and offsetting gains

Because we all face losses once in a while, it is possible to reduce your liability through tax-loss harvesting. What that means is that if some of your tokens have lost value, selling them can create realized losses that offset gains elsewhere.

Example: You earn 500$ in farming rewards, later sell them for 300, realizing a 200$ loss. That loss can offset 200$ of other gains. If your losses exceed your gains, up to 3,000$ can offset ordinary income each year. Remaining losses carry forward.

As of 2025, wash-sale rules do not apply to crypto, though Congress has debated extending them. That means you can sell a token at a loss and immediately rebuy it, still claiming the deduction. However, tax professionals have already cautioned that rules may change in the near future.

How the IRS classifies yield farming and DeFi-taxed activity

The IRS sees cryptocurrency as property. That means:

• Farming rewards are income.
• Selling, swapping, or spending tokens creates capital gains.
• Liquidity pool transactions are disposals.

Defi-taxed activities such as restaking, using yield aggregators, or depositing into complex vault strategies are still murky from a regulatory standpoint. The IRS has not yet provided direct tax guidance on whether each of these steps should be treated as income, a capital gain, or simply a non-taxable movement of assets.

While the agency has published general FAQs that outline how digital assets are classified as property, they stop short of addressing the many variations of DeFi transactions. Because of that gap, most traders and investors have to lean on interpretations put forward by tax professionals and crypto tax platforms, which apply existing property rules as best as they can.

Notice 2014-21 remains the cornerstone of cryptocurrency tax treatment. But the rapid pace of DeFi innovation has outstripped the current IRS clarity. That uncertainty is why consulting a tax professional remains critical for anyone with large-scale farming rewards.

State-level considerations and IRS audit risk

Federal law is just the first layer. States have their own tax rates, and many treat crypto the same way as property. If you live in a high-tax state like California or New York, your farming tax bill may be significantly higher than in states without income tax.

The chances of the IRS checking your tax return more closely, or even conducting a full audit, are increasing for people involved in crypto. The IRS has launched initiatives specifically targeting crypto taxes. They use blockchain analytics to trace transactions and match them against reported returns. 

If you don’t keep clear records of your DeFi transactions, it makes you look unreliable to the IRS. That raises the chance they decide to audit you, because they suspect your tax return may not be accurate.

Keeping accurate tax forms and detailed transaction logs not only ensures compliance but also provides a defense in case of IRS inquiries.

Staying compliant while farming

Yield farming is profitable but not tax-free. In the United States, farming rewards are subject to income tax when received, and later disposals will generate capital gains. Adding and removing liquidity, compounding, and even governance rewards will all carry separate tax implications.

A reliable tax calculator or crypto tax platform can reduce mistakes, but the final responsibility lies with you. The good news is that with proper planning, the system is manageable. 

You can offset gains with losses and track all these transactions with software. The IRS is watching this sector closely, but compliant farmers can enjoy their yields without fear of failing future audits.

In summary, yield farming can be lucrative, if you respect the rules, follow the current tax guidance, and treat your farming rewards as part of a legitimate investment strategy. That way, the profits you earn from farming are solid, accounted for, and far less likely to cause headaches when it comes time to file your taxes.