Crypto Lending Taxes: Complete Guide to DeFi Lending & Borrowing

Crypto lending has become one of the most popular ways to earn passive income in the digital asset space. Whether you’re depositing ETH into Aave, lending stablecoins on Compound, or earning interest through centralized platforms like BlockFi or Nexo, you need to understand how these activities are taxed.

The tax treatment of crypto lending is surprisingly complex. Interest income, receipt tokens, liquidation events, and borrowed funds all have different tax implications. Make a mistake, and you could face penalties, overpay taxes, or trigger an audit.

In this comprehensive guide, we’ll break down every aspect of crypto lending taxes so you can report accurately and confidently in 2026.

How Crypto Lending Works: DeFi vs. CeFi

Before diving into taxes, let’s understand the two main types of crypto lending platforms.

Centralized Finance (CeFi) Lending

CeFi platforms operate like traditional financial institutions. You deposit crypto with a company, and they lend it out to borrowers, paying you interest.

Popular CeFi lending platforms:

• Nexo
• Ledn
• YouHodler
• Crypto.com Earn

How it works:

1. You deposit crypto (e.g., USDC, BTC, ETH)
2. The platform lends your funds to borrowers
3. You earn interest paid daily, weekly, or monthly
4. You withdraw your principal plus earned interest

CeFi lending is straightforward from a tax perspective because interest payments are clearly identifiable and reported by the platform.

Decentralized Finance (DeFi) Lending

DeFi lending uses smart contracts to match lenders with borrowers without intermediaries. This creates additional complexity because you interact directly with protocols.

Popular DeFi lending protocols:

• Aave (Ethereum, Polygon, Arbitrum, and more)
• Compound (Ethereum)
• MakerDAO (Ethereum)
• Spark (formerly MakerDAO’s DAI Savings Rate)
• Morpho
• Radiant Capital
• Benqi (Avalanche)
• JustLend (TRON)

How it works:

1. You deposit tokens into a lending pool
2. You receive “receipt tokens” (aTokens, cTokens, etc.)
3. Interest accrues automatically through token mechanics
4. You redeem receipt tokens for your principal plus interest

DeFi lending creates unique tax challenges because of receipt tokens and continuous interest accrual. Awaken Tax handles these complex mechanics automatically across 10,000+ protocols.

Tax Treatment of Interest Income from Lending

The most important thing to understand about crypto lending taxes is this: interest earned is taxable as ordinary income.

When Is Interest Taxable?

Interest becomes taxable when you have “dominion and control” over it. In practice:

CeFi platforms: Interest is taxable when credited to your account, even if you don’t withdraw it.

DeFi protocols: Interest is taxable when you have the ability to claim or redeem it.

Tax Rate on Crypto Interest

Crypto interest is taxed as ordinary income, not capital gains. This means it’s taxed at your marginal income tax rate, which can be as high as 37% for federal taxes (plus state taxes).

Income Level (Single Filer 2025)	Tax Rate
Up to $11,600	10%
$11,601 - $47,150	12%
$47,151 - $100,525	22%
$100,526 - $191,950	24%
$191,951 - $243,725	32%
$243,726 - $609,350	35%
Over $609,350	37%

Reporting Interest Income

Report crypto interest income on Schedule 1 (Form 1040) as “Other Income.” If you earned over $600 in interest from a CeFi platform, you may receive a 1099-MISC or 1099-INT.

Example:

• You deposit 10,000 USDC into Aave
• Over the year, you earn 500 USDC in interest
• Report $500 as ordinary income (assuming USDC = $1)

How aTokens and cTokens Work: Tax Implications

DeFi lending protocols use “receipt tokens” to represent your deposit plus accrued interest. Understanding how these work is crucial for accurate tax reporting.

Aave: aTokens

When you deposit assets into Aave, you receive aTokens (e.g., aUSDC, aETH, aDAI). These tokens represent your deposit and accrue interest continuously.

How aTokens work:

• Your aToken balance increases every block
• The increase represents interest earned
• 1 aToken is always redeemable for approximately 1 underlying token (plus accumulated interest)

Tax treatment:

• The continuous increase in your aToken balance is taxable interest income
• When you redeem aTokens for underlying tokens, calculate any additional gain/loss

Example:

• Day 1: Deposit 1,000 USDC, receive 1,000 aUSDC
• Day 365: You now have 1,050 aUSDC due to interest
• The 50 aUSDC increase represents $50 of ordinary income

Compound: cTokens

Compound uses a different mechanism. Your cToken balance stays the same, but the exchange rate increases over time.

How cTokens work:

• You receive cTokens at the current exchange rate
• The exchange rate increases as interest accrues
• Your cToken balance doesn’t change; each cToken becomes worth more

Tax treatment:

• Interest income is recognized when you redeem cTokens
• The difference between redemption value and deposit value is ordinary income
• Some tax professionals argue income should be recognized continuously

Example:

• Day 1: Deposit 1,000 USDC, receive 50,000 cUSDC (exchange rate 0.02)
• Day 365: Exchange rate is now 0.021
• Redemption: 50,000 cUSDC × 0.021 = 1,050 USDC
• Report $50 as ordinary interest income

Cost Basis of Receipt Tokens

Determining the cost basis of aTokens and cTokens is essential for calculating gains when you eventually sell or trade them.

For aTokens:

• Initial cost basis = Fair market value of deposited tokens
• As interest accrues and balance increases, new tokens have a cost basis equal to their fair market value when received

For cTokens:

• Cost basis = Fair market value of deposited tokens
• The entire gain upon redemption may be treated as interest income

This is exactly why specialized software matters. Awaken Tax automatically tracks receipt token mechanics across Aave, Compound, and dozens of other lending protocols.

Borrowing Against Crypto: NOT a Taxable Event

Here’s good news for crypto borrowers: taking out a loan against your crypto collateral is NOT a taxable event.

Why Borrowing Isn’t Taxed

When you borrow against crypto:

• You’re not selling or disposing of your assets
• You still own the collateral (it’s just locked)
• You have an obligation to repay the loan
• No gain is “realized” until you sell

This is the same as taking out a mortgage against your home or a margin loan against stocks.

How Crypto Borrowing Works

On platforms like Aave, Compound, or MakerDAO:

1. Deposit collateral (e.g., ETH, wBTC)
2. Borrow up to a certain percentage (loan-to-value ratio)
3. Receive borrowed funds (e.g., USDC, DAI)
4. Pay interest on the loan
5. Repay the loan to unlock collateral

Example:

• Deposit 10 ETH worth $25,000
• Borrow 15,000 DAI (60% LTV)
• This is NOT a taxable event
• You don’t realize any gain on your ETH

Strategic Tax Benefits of Borrowing

Borrowing against crypto can be a tax-efficient strategy:

• Access liquidity without triggering capital gains
• Keep assets for long-term holding period
• Potentially deduct interest (see below)
• Avoid short-term capital gains rates

However, this strategy carries risks, including liquidation if your collateral value drops.

Interest Paid on Crypto Loans: Deductibility Rules

Can you deduct the interest you pay on crypto loans? The answer depends on how you use the borrowed funds.

Investment Interest Deduction

If you borrow against crypto to invest, interest may be deductible as “investment interest expense.”

Requirements:

• Borrowed funds must be used for investments
• Deduction limited to net investment income
• Must itemize deductions (Schedule A)
• Cannot deduct against tax-exempt income

Example:

• You borrow 10,000 DAI against ETH collateral
• You use the DAI to buy more crypto
• Interest paid may be deductible as investment interest

Business Use

If you borrow crypto for business purposes, interest may be deductible as a business expense.

Personal Use: Generally NOT Deductible

If you borrow against crypto for personal expenses (buying a car, paying bills), the interest is not tax deductible. This is similar to personal credit card interest.

Mortgage Interest? No.

Even if you use borrowed crypto to buy a home, it does not qualify for the mortgage interest deduction. The deduction only applies to loans secured by the home itself.

Documentation is critical. Keep records of how you used borrowed funds to support any interest deductions.

Liquidation Events: The Critical Tax Trigger

While borrowing isn’t taxable, liquidation of your collateral IS a taxable event. This catches many crypto users off guard.

What Is Liquidation?

Liquidation occurs when your collateral value drops below the required threshold. The protocol automatically sells your collateral to repay the loan.

Example scenario:

1. Deposit 10 ETH worth $25,000
2. Borrow 15,000 DAI (60% LTV)
3. ETH price drops 40%
4. Your 10 ETH is now worth $15,000
5. Protocol liquidates your ETH to repay the loan

Tax Treatment of Liquidation

When your collateral is liquidated:

1. You’re treated as having sold the collateral
2. Calculate gain/loss based on your cost basis
3. Report on Schedule D and Form 8949

Example:

• Original ETH purchase: 10 ETH at $1,500 each = $15,000 cost basis
• Liquidation: 10 ETH sold at $1,500 each = $15,000 proceeds
• Capital gain/loss: $0 in this case

But often liquidation happens at a loss:

Example with loss:

• Original purchase: 10 ETH at $2,500 each = $25,000 cost basis
• Liquidation: 10 ETH sold at $1,500 each = $15,000 proceeds
• Capital loss: $10,000

Partial Liquidations

Many protocols allow partial liquidation, where only enough collateral is sold to restore the health factor. Track each partial liquidation as a separate taxable event.

Liquidation Penalties

Most protocols charge a liquidation penalty (typically 5-15%). This penalty reduces your proceeds, increasing your loss or reducing your gain.

The complexity of tracking liquidations across multiple protocols is exactly why Awaken Tax was built. Try it free and see how it handles even your most complex DeFi positions.

Flash Loans: Unique Tax Treatment

Flash loans are uncollateralized loans that must be borrowed and repaid within a single blockchain transaction. They’re used for arbitrage, liquidations, and other advanced DeFi strategies.

Are Flash Loans Taxable?

The flash loan itself is not taxable because:

• No asset is actually held
• Everything happens in one atomic transaction
• You never have “dominion and control” over borrowed funds

What IS Taxable

The profits from flash loan strategies are taxable:

• Arbitrage profits = ordinary income or capital gains
• Liquidation profits = ordinary income
• Fees paid for the flash loan = may be deductible as a cost

Example:

• You execute a flash loan arbitrage
• Borrow 1,000,000 DAI
• Swap for USDC at a slight premium
• Repay loan + fee
• Profit: 500 DAI

The $500 profit is taxable income.

Reporting Flash Loan Activity

Flash loan profits should generally be reported as ordinary income if you’re actively trading. If flash loans are part of a business, report on Schedule C.

Step-by-Step Calculation Examples

Let’s walk through complete examples of crypto lending tax calculations.

Example 1: Simple CeFi Lending

Scenario:

• January 1: Deposit 10,000 USDC into Nexo
• Earn 8% APY paid monthly
• December 31: Withdraw 10,800 USDC

Tax calculation:

• Interest earned: $800
• Report as ordinary income
• Cost basis of the 800 USDC received: $800

Example 2: DeFi Lending with Aave

Scenario:

• March 1: Deposit 5 ETH (value $10,000) into Aave
• Receive 5 aETH
• December 31: aETH balance is now 5.15 aETH
• ETH price is now $3,000

Tax calculation:

• Interest earned: 0.15 ETH × $3,000 = $450 (at time of accrual, calculate based on price when received)
• Report $450 as ordinary income
• Your 5.15 aETH has a cost basis of $10,000 (original) + $450 (interest) = $10,450

Example 3: Borrowing and Liquidation

Scenario:

• January 1: Deposit 10 ETH (cost basis $15,000, current value $20,000) into Aave
• January 15: Borrow 12,000 USDC
• June 1: ETH crashes, 8 ETH liquidated at $1,800 each

Tax calculation:

Borrowing (January 15): NOT taxable

Liquidation (June 1):

• Proceeds: 8 ETH × $1,800 = $14,400
• Cost basis: 8 ETH × $1,500 = $12,000
• Capital loss: $14,400 - $12,000 = $2,400 gain

Wait, that’s actually a gain because the cost basis was $1,500/ETH (from original purchase) even though the market price dropped. This is why tracking cost basis matters.

Example 4: Compound cToken Redemption

Scenario:

• February 1: Deposit 20,000 DAI into Compound
• Receive 1,000,000 cDAI (exchange rate: 0.02)
• November 1: Redeem all cDAI
• Exchange rate now: 0.0208

Tax calculation:

• Redemption value: 1,000,000 × 0.0208 = 20,800 DAI
• Interest earned: 800 DAI = $800 ordinary income
• Cost basis of cDAI: $20,000
• Cost basis of 20,800 DAI received: $20,800

Using the DeFi Tax Calculator

To simplify these calculations, use our DeFi Tax Calculator. It helps you:

• Calculate interest income from lending
• Determine cost basis of receipt tokens
• Estimate taxes on liquidation events
• Track borrowing positions

For comprehensive automated tracking across all your DeFi lending positions, Awaken Tax connects directly to your wallets and handles everything automatically.

Common Crypto Lending Tax Mistakes

Mistake 1: Ignoring Receipt Token Mechanics

Many users don’t realize that aTokens and cTokens have unique tax implications. Simply treating them as “the same as the underlying” can lead to incorrect reporting.

Solution: Use tax software that understands lending protocol mechanics.

Mistake 2: Not Reporting CeFi Interest

Just because you didn’t receive a 1099 doesn’t mean interest isn’t taxable. All interest must be reported regardless of whether the platform issued tax forms.

Solution: Track all interest earned throughout the year.

Mistake 3: Thinking Loans Are Income

Some users mistakenly report borrowed funds as income. Remember: borrowing is NOT a taxable event.

Solution: Keep borrowing transactions separate from income-generating events.

Mistake 4: Missing Liquidation Events

Liquidations often happen automatically when you’re not watching. Failing to report them can trigger IRS scrutiny.

Solution: Monitor your positions and use software that tracks liquidations.

Mistake 5: Wrong Cost Basis on Interest

The cost basis of interest received should be the fair market value when you receive it, not $0.

Solution: Record the value of interest at the time of receipt.

Mistake 6: Deducting Non-Deductible Interest

Not all loan interest is deductible. Personal-use interest cannot be deducted.

Solution: Only deduct interest on loans used for investment or business.

Mistake 7: Ignoring Cross-Protocol Activity

Using multiple lending protocols without tracking each one leads to incomplete reporting.

Solution: Use comprehensive software like Awaken Tax that supports 10,000+ protocols.

Mistake 8: Forgetting About Gas Fees

Gas fees for depositing, withdrawing, and claiming interest can be added to cost basis or treated as expenses.

Solution: Track all gas fees associated with lending activities.

Best Practices for Crypto Lending Taxes

Keep Detailed Records

Document every lending-related transaction:

• Deposits and withdrawals
• Interest payments received
• Loans taken and repaid
• Liquidation events
• Gas fees paid

Use Specialized Software

Manual tracking of lending positions across multiple protocols is extremely difficult. Awaken Tax automates this process:

• Automatically recognizes deposits to Aave, Compound, MakerDAO, and thousands of other protocols
• Correctly categorizes interest income
• Tracks receipt token cost basis
• Identifies liquidation events
• Generates IRS-compliant tax forms

Consult a Tax Professional

For complex situations involving large amounts or multiple protocols, consider consulting a crypto-specialized CPA.

Stay Informed About Regulatory Changes

The IRS continues to develop guidance on crypto lending. Stay updated on new rules that may affect your reporting.

Conclusion

Crypto lending taxes don’t have to be overwhelming. By understanding the key principles - interest is ordinary income, borrowing isn’t taxable, but liquidation is - you can navigate the complexity confidently.

The most important steps are:

1. Track all interest income from both CeFi and DeFi platforms
2. Understand receipt token mechanics for aTokens, cTokens, and similar
3. Know that borrowing isn’t taxable but liquidation triggers capital gains/losses
4. Document everything including the use of borrowed funds for potential deductions
5. Use specialized software that understands DeFi protocol mechanics

For the easiest path to accurate crypto lending tax reporting, start your free trial with Awaken Tax. With support for 10,000+ DeFi protocols including all major lending platforms, Awaken handles the complexity so you can file with confidence.

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