Cryptocurrencies and blockchain technology encompass a breakthrough technology enabling individuals around the world to permissionlessly communicate and transact in ways never previously contemplated. One application of blockchain is known as decentralized finance, or DeFi. Through DeFi, lenders and borrowers can transact with one another without a centralized intermediary or cumbersome paperwork and other approvals. But with great technological advancement come unique regulatory issues. One such issue is how to determine tax liability for lenders and liquidity providers, or LPs, participating in DeFi. This issue arises due to the nature of yields earned through DeFi. In traditional financial systems, lenders gain interest in the U.S. Dollar. 

Through DeFi, lenders and LPs can earn yields through various capital assets, such as Bitcoin and Ether, which themselves can also gain or lose value over time. This Article proposes a simple solution. Under the “system in, system out” approach, a taxpayer would recognize a taxable event only after funds are removed from the applicable decentralized application, or DApp. In other words, a lender or LP could park his or her assets in a DApp for an indefinite amount of time without recognizing any taxable income or capital gain or loss. This approach will likely offer numerous, significant, benefits including easing the burden on taxpayers and the IRS, encouraging productive use of assets, incentivizing innovation, and encouraging participation in emerging technology.