Are you thinking of taking out a crypto loan or lending your crypto to earn interest - or perhaps already done so? Whether you’re a borrower or a lender, it’s essential to understand the tax implications of crypto loans so you’re not left at the end of the year scratching your head wondering just how much your tax bill will be.
This guide will cover crypto loan taxes from all angles:
- Receiving the loan
- Spending the loan proceeds
- Loaning crypto
- Income received from loaning crypto
- Interest paid on the loan
- Paying off the loan
- Non-repayment of the loan
- Liquidation of collateral
Receiving a crypto loan
Receiving funds by depositing crypto as collateral is not taxable. This is similar to taking out a loan by providing equity shares as collateral.
Spending crypto loan proceeds
Spending the cash received from crypto loans is also not taxable. However, if you don’t repay the loan, this will lead to a taxable event as you now have cancellation of debt (COD) income.
Loaning crypto to earn income
Whether you loan crypto on a centralized or decentralized exchange makes a tax difference.
Loaning crypto on a centralized exchange is not taxable since there is no disposal of crypto assets. When you lend your crypto, you do not receive any token in return, unlike what happens on decentralized exchanges.
The reason decentralized exchanges have tax implications is due to the way the loan results in a crypto-to-crypto swap.
Take for example if you were to loan your crypto on a DeFi protocol like Aave or Compound.
Your crypto would be part of a pool. When you deposit your crypto in this pool, you will receive a separate token which represents your ownership in the pool.
Since the IRS views crypto-to-crypto trades as disposals, the above transaction of receiving aETH by loaning ETH on Aave may be taxable.
Furthermore, loaning crypto on a decentralized exchange may be subject to either income tax or capital gains tax depending on the platform being used and how it works.
When an investor loans crypto on a DeFi platform they earn two types of income: 1) interest on the crypto lent and 2) platform rewards.
Say for example if Andrew lends USDC on Compound he will earn 1.05% per annum as Interest and additionally he will earn 0.51% per annum in the form of Compound tokens (see screenshot below).
Here are the tax implications:
1) Interest on loaning crypto assets
Interest received on loaning crypto is treated as ordinary Income and taxed at applicable income tax bracket rates.
Platform tokens received for loaning crypto on the platform are also treated as ordinary income and similarly taxed at applicable income tax bracket rates.
Interest paid on crypto loans
Interest paid on the loan can be written off as an expense in the tax return if the loan amount is used for investment or business purposes.
Investment purposes would include investing in crypto assets, stocks, securities, bonds, etc. The interest amount can be claimed as an investment interest expense in IRS Form 4952.
Business purposes would include situations where the loan amount is invested in rental property, ongoing business, or any other business to make a profit.
Otherwise if you took out the loan for personal purposes e.g. the purchase of groceries, furniture, a car, etc. then these expenses are personal and are NOT deductible.
Paying off the crypto loan
When an investor pays the loan amount and receives his collateral back, this is not considered a tax event and hence is not taxable.
Continuing the earlier example, if Andrew repays the $10,000 loan and receives back his 1 BTC, this is not a taxable event for him irrespective of the fact that the BTC price would have increased during the period it was locked as collateral.
Non-repayment of the loan
If you do not pay back the loan within the specified period then the platform can liquidate your holdings to recover the loan amount with interest. This liquidation will be treated as a disposal of assets and will lead to capital gains tax.
Therefore, defaulting on a crypto loan is not a way to cash out and escape taxes. Be prompt in repayment to avoid any unforeseen tax bills.
Liquidation of collateral
Liquidation occurs if the value of the collateral falls below a limit set by the platform. On liquidation, it will be treated as a disposal of assets and capital gains would be due.
If the price of BTC falls below $12,000, the platform will liquidate Andrew’s collateral and he will incur a capital gain of $11,000 ($12,000 liquidation price - $1,000 buy price)
Ensure you keep adequate collateral to avoid liquidations.
How to track your crypto loans and simplify your taxes at year end with Bitwave
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Disclaimer: The information provided in this blog post is for general informational purposes only and should not be construed as tax, accounting, or financial advice. The content is not intended to address the specific needs of any individual or organization, and readers are encouraged to consult with a qualified tax, accounting, or financial professional before making any decisions based on the information provided. The author and the publisher of this blog post disclaim any liability, loss, or risk incurred as a consequence, directly or indirectly, of the use or application of any of the contents herein.