What is an impermanent loss?

Are you someone who has already interacted with a DEX like SushiSwap, or PancakeSwap? If so, you’re (hopefully) already familiar with the concept of an impermanent loss. If you’re looking to get into the world of crypto liquidity protocols, then impermanent loss is a very important concept to understand. Let’s look at what an impermanent loss is in the crypto world, and how it might impact your tax obligations.

What is an impermanent loss?

Impermanent loss is the term given to an outcome where an individual has provided liquidity to a liquidity pool, but the value of the assets they deposited has changed since they did so.

Example:

Bob deposits 1 ETH and 20 AAVE into a liquidity pool on Uniswap. This liquidity pool requires paired assets to be of equivalent value, so in this example, the price of 1 ETH would be equal to 20 AAVE. At the time, 1 ETH is valued at $1,300 USD. Consequently, the total value in fiat currency at the time of deposit would be equivalent to $2,600 USD.

In return, he receives a proportional amount of LP tokens associated with that pool. These tokens represent Bob’s stake of the pool as a whole. Let’s say his contribution of 1 ETH / 20 AAVE equates to 5% of the total pool’s value. This means that the pool consists of 20 ETH / 400 AAVE.

During the time in which Bob has his assets in this liquidity pool, the value of 1 ETH increases from 20 AAVE to 40 AAVE. As mentioned before, this liquidity pool requires paired assets to be of equivalent value, so arbitrage traders have to step in to make this so. After their work is done, the pool would then consist of 10 ETH / 800 AAVE. At this point, Bob is still entitled to 5% of the liquidity pool’s shares.

This means he can withdraw 0.5 ETH and 40 AAVE. With ETH still at a value of $1,300 USD but AAVE now at a value of $10 USD, this would have a combined value of $1050 USD. If Bob had not participated in the liquidity pool and had just held his 1 ETH and 20 AAVE, he would have assets to the value of $1,500 USD. As this is higher than what he could currently withdraw from the liquidity pool, it is termed an ‘impermanent loss’. If Bob chooses to withdraw his assets at this loss, it changes from an impermanent loss to a permanent loss.

What are the potential tax implications of impermanent losses?

The process of providing liquidity, and the resultant LP tokens and their properties are a grey area in most tax jurisdictions. It is important that you discuss these transactions in-depth with your personal accountant so they can take into consideration your personal situation, and how these transactions may affect your tax obligations.

Based on the guidelines we’ve received from tax lawyers, we have taken the conservative method of dealing with liquidity pool transactions in our platform. When you deposit your tokens into the pool, effectively you are 'disposing' of the tokens (relinquishing control of them) and receiving an LP token, with substantially different properties, in return. Our platform categorizes this initial deposit into the pool as a 'sell' or 'disposal'. The receipt of the LP token is categorized as a 'buy' using the proceeds of the prior 'sell'. This creates a taxable event on our platform, where you may realize capital gains from the 'sell' of the deposited tokens. The redemption of the LP token works in the reverse process, with the LP token being categorized as a 'sell' and the deposited tokens (plus generated fees/yield) being received are categorized as a 'buy' using the proceeds of the LP token. If the LP position has changed in value between the initial deposit and the final withdrawal, this will be classified as a taxable event on our platform.

As mentioned before, liquidity pool related transactions are a grey area in most tax jurisdictions. Summ (formerly Crypto Tax Calculator) uses the method outlined above, where each step of the liquidity provision is a taxable event. This ensures our users are best positioned for future clarification of these complex transactions. If this is to be clarified as a chain of taxable events in the future (as the platform accounts for) users will be positioned correctly in terms of their tax obligations. If we were to take the stance that this was not a chain of taxable events, and future clarification went against this assumption, many of our users would be impacted and have unfulfilled tax obligations. Again, it is very important you clarify this process of events with your local tax professional to ensure your taxable obligations are fulfilled in your personal circumstances.