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How Uniswap taxes work

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Uniswap is a decentralized peer-to-peer cryptocurrency exchange that allows you to trade ERC 20 tokens. The Uniswap exchange is different from a traditional exchange like Coinbase, where your transactions are processed through an intermediary.

The tax code did not cover how taxes work for Uniswap transactions. However, there are enough guides for doing this shut down Some of the tax ramifications of transactions in this unique DeFi exchange. This two-part series gives you a general overview of how Uniswap Exchange works and the tax implications of various transactions.

What is Uniswap?

Understanding the technical details and the underlying economics behind the Uniswap platform is outside the discussion of this post. If you are curious about how it actually works, I highly recommend reading this guide posted on the website. This introduction is enough to get a basic understanding of the platform and apply tax rules to different transactions.

If you are new to crypto, Uniswap is a somewhat elusive concept. The easiest way to get a good understanding of the Uniswap platform is to examine three elements (Liquidity, trading activity & fees) Every crypto exchange needs and how Uniswap treats them differently.

First, Uniswap relies on users’ funds to create liquidity. It does this by allowing users to participate in pools of liquidity. The way these work is something unique. If you want to participate in a liquidity pool, you basically have to deposit ether and a corresponding amount of another ERC 20 token at the same time. Let’s say the price of 1 ETH is $ 200. If you wanted to participate in the ETH / cDAI liquidity pool, you would deposit 1 ETH and 200 cDAI, assuming the price of 1 cDAI is $ 1. Your total US dollar deposit is $ 400. 1 ETH to 200 cDAI is the initial “deposit ratio”. As soon as the pair is deposited, Uniswap will send you a liquidity token called “UNI-V1” which represents your deposit ratio.

You may be wondering why someone would provide liquidity. The Uniswap platform charges a flat 0.3% fee when users trade ERC 20 tokens (also known as swap). Liquidity providers receive a proportional share of these transaction fees based on the amount of liquidity provided. In a central exchange like Coinbase, these transaction fees would go public. It will not be distributed among the participants.

After you’ve deposited your first pair into the liquidity pool, the initial deposit ratio may change depending on trading activity. If you stick to the example above, regular trading activities of other participants in the ETH / cDAI pool may add more (or less) ETH or cDAI to the pool. This would proportionally affect your initial 1: 1 deposit ratio. In the example above, if you leave your first deposit on the platform for a while, you might see 1.2 ETH to 150 cDAI. This ratio changes continuously.

Another unique aspect of Uniswap compared to a traditional exchange is that the exchange rate of tokens on the platform is determined by the ratio of the funds deposited in a given pool. In contrast, traditional exchanges determine the USD price of tokens based on supply and demand. Supply and demand are shown in the order book.

Finally, liquidity providers can withdraw their funds by burning liquidity tokens (UNI-V1). When they do retrieve the funds, their initial deposit ratio has most likely changed due to trading activity on the platform.

As you can see, using Uniswap is more complicated than trading through a central exchange (or a decentralized exchange) with a traditional order book. Before analyzing the tax implications, it is important to understand how Uniswap works. In the next post, we will look in depth at the tax implications of the above events.

Disclaimer: This post is for information only and is not intended as tax advice. For tax advice, please contact a tax advisor.

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