1️⃣ Adding Liquidity (Depositing Assets)

When you deposit crypto — say, ETH and USDT — into a pool and receive LP tokens, the IRS treats this like a trade of crypto for another crypto asset.

You must recognize capital gains or losses based on the difference between the purchase price and market value at the time of deposit.

🧩 Example:

• You purchased 2 ETH for $2,800 total.
• When you deposit into a pool (along with $2,800 USDT), ETH’s value has increased to $3,400.
• You’re treated as disposing of that ETH — reporting a $600 capital gain.
• The new LP token is recorded as worth $6,200 (combined ETH + USDT value).

Even though you’re “just adding liquidity,” the IRS views it as an exchange, so it’s taxable.

2️⃣ Removing Liquidity (Withdrawing Assets)

When you redeem your LP tokens for pool assets, it’s another disposal event — you exchange LP tokens for crypto.

🧩 Example:

• LP token acquired at $6,200.
• When you withdraw, you receive $2,900 ETH + $2,700 USDT = $5,600.
• You realize a $600 capital loss.

💡 Impermanent Loss:
The mix of tokens you receive can differ due to price fluctuations — for instance, withdrawing $2,500 ETH and $3,100 USDT instead of equal values.
These shifts create IL, a key DeFi risk to monitor.

3️⃣ Rewards and Yield

Rewards (like liquidity mining tokens or yield distributions) are treated as ordinary income, not capital gains.

🧩 Example:
You receive $80 of UNI tokens as liquidity rewards.
At receipt, you report $80 as income.
If you later sell those UNI tokens, any price change is taxed as a capital gain or loss.