Getting a fiat loan against your appreciated cryptocurrency is a great way to cash out without paying capital gains taxes. In this post, let’s dissect various transactions associated with a crypto-backed loan and understand tax implications.
Receiving cryptocurrency loan proceeds
Receiving cash for depositing your cryptocurrency as collateral is not a taxable event.
This is similar to getting a home equity line of credit where you collateralize your home with the bank and get cash against the appreciated property value.
For example, Sam purchased 1 bitcoin (BTC) in 2017 for $1,000. It is now worth $50,000. Sam decides to put this BTC as collateral in a lending platform and get a loan. The lending platform offers him a $30,000 loan. This $30,000 is not taxable to Sam. He doesn’t have to report this amount in any tax forms although this would trigger him to check “yes” on the virtual currency question on Page 1.
Spending the loan proceeds
Spending the cash received is not a taxable event either. You can spend the cash proceeds for anything you like. However, just know that if you don’t pay back the loan, that will lead to a taxable event.
Interest expense on cryptocurrency loans
Cryptocurrency lending platforms charge you an annual interest rate for lending cash against your cryptocurrency. This rate is about 5%. You can write-off the interest expense on your taxes if you use the loan proceeds for either investment or business purposes.
Investment purposes include investing the loan proceeds to purchase other cryptocurrencies or investing in traditional assets like stocks and securities. If this is the case, crypto loan interest expense is deductible on your tax return as investment interest expense on Form 4952.
A business purpose would be a situation where you invest the loan proceeds in a rental property or an ongoing business with the intention of making profits. Here, your crypto loan interest expense is deductible on the appropriate business tax return.
Note that if you are using the crypto loan proceeds to cover personal expenses such as groceries, furniture, or a car, interest expense would not be deductible.
Paying off the cryptocurrency loan
Generally speaking, paying back the loan and receiving the collateral back is not a taxable event. Going with the example above, say Sam paid back $30,000 to the lending platform and received back the 1 BTC he deposited. This is not a taxable event for him even if the price of BTC has gone up in value while it was locked as collateral.
As you can see, when handled correctly, cryptocurrency-backed loans do not result in any taxes. With that said, the IRS could technically argue that cryptocurrency loans are taxable because cryptocurrencies like bitcoin are not considered fungible like fiat. However, the chances of cryptocurrency loans being treated this way are remote.
When do you have to pay taxes on crypto loans?
There are a couple of situations where you could have a tax obligation related to a crypto-backed loan.
First, if you don’t pay back the loan, the platform will liquidate your collateral to cover their losses creating an unintended tax bill for you. Say Sam decided not to pay back the $30,000 loan. On this day, BTC is trading at $31,000 a coin. In this case, the platform can liquidate his 1 BTC subjecting Sam to a $30,000 ($31,000 – $1,000) capital gain. Thus, defaulting on a cryptocurrency-backed loan is not a path to cash out without paying capital gains taxes.
Second, you could also face a liquidation of collateral if the price of bitcoin falls down below a certain threshold set by the lending platform. To avoid liquidation and taxes, you will either have to add more collateral or pay off the loan.
Disclaimer: This post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.