If you are in the DeFi space, chances are you have come across the term “impermanent loss”. This is an important concept for investors to understand related risks when participating in decentralized finance.

In this blog, you’ll learn everything about the impermanent loss in crypto and its tax implications. We also explain a few solid tips so that you can avoid this as a crypto investor.

What Is Impermanent Loss In Crypto?

Impermanent loss is the apparent loss that you incur when you provide liquidity to the DeFi liquidity pools you are participating in, and the profit you earn from staking the tokens in the pool is less than what you would have earned if you held them yourself.

It happens because the market price of the deposited tokens at the time of withdrawal changes compared to your deposit time. The more the price change, the greater the impermanent loss incurred. 

This loss is called “impermanent” because you may recover the losses if you don’t withdraw your assets and their market price returns to your initial purchase price. 

So, Why Do Liquidity Providers Give Liquidity Inspite Of The Impermanent Loss Risk?

This is because the trading fees earned by the liquid providers each time they provide liquidity to the assets in the pool can make up for the impermanent losses. This can make the overall process profitable for the liquidity providers.

Also, you can prevent impermanent losses if you just HODL your assets instead of withdrawing them during that specific time. 

However, this may vary depending on the pool you are participating in, its protocols, the type of assets pooled, and the market condition.

How To Calculate Impermanent Loss?

Impermanent loss is a percentage loss you would experience if the token’s price ratio changes than at the time of deposit. Note, this is without the trading fees of the pool.

Use this formula to calculate your impermanent loss:

Impermanent Loss = (2√price_ratio / 1+ price_ratio) - 1

Where,

price_ratio is the ratio between the market price of the token at the time of deposit and at the time of withdrawal.

If you want to dive deeper, here’s an excellent derivation for the above formula.

How Does Impermanent Loss Work?

So, impermanent losses occur when the prices of your tokens in the pool change. But how does it exactly work? Let us understand this with the help of an example.

If you have two tokens, for instance, USDT and SOL worth $1 and $20 respectively at the time of funding a 50:50 USDT/SOL liquidity pool. You have to provide an equal ratio of both tokens to the pool (i.e. tokens worth the same in fiat currency)

Let’s say you invest $1000 in the pool. Since it’s 50:50, you provide $500 USDT ( 500 USDT tokens) and $500 SOL (25 Solana tokens).

Now, if the price of the SOL increases, for instance, $22, it opens up an opportunity for arbitrage traders since the price of SOL is lower in your pool than in external exchanges. The smart contracts of the AMM are set in such a way that the token ratio in the pool remains constant. 

So, when the price of SOL goes up, the amount of SOL tokens in your token pair will decrease and the USDT will increase to a point where the price of SOL and USDT becomes constant in your pair. 

In this case, it will come back to equilibrium when your token pair has 524.40 USDT and 23.84 SOL. If you now decide to provide liquidity, the value of the token pair will be $1048.81.

However, if you have held the token yourself – you would have 500 USDT and 25 SOL worth $1050. You incur an impermanent loss of 0.11%  from the trade even though you have realized capital gains from a tax perspective.

How To Avoid Impermanent Losses?

While you can’t avoid impermanent loss, here are four tips to help reduce its occurrence.

Opt For Low Volatility Pairs

The more the price of your crypto asset changes, the greater the chances of IL. One way to avoid it is to opt for stablecoins or less volatile pairs (e.g. USDT and DAI). Since the prices of these tokens do not fluctuate much, the risk of impermanent loss significantly reduces.

Use Multi-Crypto Asset Liquidity Pools

Liquidity pools don't always require you to invest in 50:50 crypto pairs. Some DeFi exchanges allow you to invest in two or more tokens at varying ratios. For instance, investing in a crypto pair with 80% stablecoins and 20% volatile tokens mitigates the risk of impermanent loss since a major portion of the token price will remain stable.

Earn As Passive Income

Holding your crypto assets and using them in the passive income approach helps you reduce risks of several risks that come with the market volatility including impermanent loss. This also helps you reduce your tax liabilities.

Use Impermanent Loss Protection (ILP) Program

Many DeFi protocols, for instance, ThorChain, have Impermanent Loss Protection (ILP) programs to ensure that the users either make a profit or at least meet the break even when they decide to liquify the pool.

This is done by filling in the loss using the decentralized protocol’s treasury. The losses are completely covered after a minimum period of holding time (i.e. 100 days) and partially covered before that point.

What Are The Tax Implications Of Impermanent Loss?

There are no defined rules for impermanent loss in most jurisdictions which can turn its taxes quickly complex. However, with all the information available, it can be interpreted that:

• When you sell your tokens for the LP token pair, it is considered a trade and is taxable which needs to be reported whether or not you gain any capital gains. This is because you effectively “sell” your crypto tokens to “buy” LP token of a different nature and properties.

• When you withdraw your funds from the pool, you are trading your LP tokens back into the pool. If you now make a profit from the initial buying price of your LP token, you will realize capital gains and pay capital gains tax on your trade. This is because even if you incur a loss than what you have earned if you have held those tokens yourself, you are actually making a profit on your trade

Since the tax implications on liquidity pool transactions are still in the grey area, it’s important to discuss all the details with your accountant to report taxes correctly. 

To simplify the process, Kryptoskatt automatically detects any taxable events and your realized capital gains from thousands of transactions. Simply add your wallet or exchanges to the platform – the app auto-syncs your transaction history and generates tax reports that comply with your country’s regulations.

FAQs:

What is impermanent loss?

Impermanent loss is the apparent loss that you incur when you provide liquidity to the DeFi liquidity pools you are participating in, and the profit you earn from staking the tokens in the pool is less than what you would have earned if you held them yourself.

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How does impermanent loss happen?

Impermanent loss is a percentage loss you would experience if the token’s price ratio changes than at the time of deposit. Note, this is without the trading fees of the pool.

Use this formula to calculate your impermanent loss:

Impermanent Loss = (2√price_ratio / 1+ price_ratio) - 1

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What is impermanent loss protection?

Impermanent loss protection (ILP) is a program introduced by several exchanges and DeFi protocols which ensures the traders either make a profit or at least break even when they provide liquidity to the pool. If there’s any loss that occurs, the protocols fill it up from their treasury. 

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What does it mean for taxes?

There are no defined tax laws for impermanent loss or liquidity pool transactions. However, with current rules in place, the entire process is seen as a trade and is subject to tax as follows:

• When you dispose of your crypto tokens to buy LP token, it is considered taxable and you may incur a capital gain
• When you dispose of your LP token (provide liquidity to the pool) and realize capital gains