Crypto Loans and Your Taxes

Zac McClureUpdated at: Nov 30th, 2021

What is a crypto loan?

A crypto loan is a way for traders to receive liquid funds without selling their cryptocurrency. Instead, they use their crypto as collateral for a cash or stablecoin loan.

Individuals may choose to take out a crypto loan instead of selling because they expect their crypto asset’s value to increase or because they want to hold the asset long enough to avoid short-term capital gains tax.

What are the categories of crypto loans?

Custodial crypto (CeFi) loans

Centralized finance (CEFi) loans are custodial; a central entity takes custody of collateral. In this situation, a trader cannot access his or her collateralized assets; the lender controls the assets’ private keys.

The takeaway here is that although custodial crypto loans are still far more accessible and affordable than traditional loans, they still depend on a centralized lending provider to enforce their terms. Around 80 percent of crypto loans are currently custodial, but this ratio is changing quickly.

Non-custodial (DeFI) crypto loans

Decentralized finance (DeFi) loans are non-custodial. Rather than depending on a central organization to enforce the terms of the loan, they depend on smart contracts. If a trader takes out a DeFi crypto loan, the trader retains control of their assets’ keys—unless they default on the loan.

DeFi platforms cannot directly lend fiat currency; traders receive stablecoins that can then be exchanged for cash. DeFi loans tend to have a higher interest rate than custodial loans.

What do I need to take out a crypto loan?

Compared to the process of applying for a traditional loan, applying for a crypto loan requires relatively little. Credit checks are typically not required; rather, the amount of the loan you will be approved for depends upon the amount of collateral you are able to use. The loan-to-value (LTV) ratio is the ratio between the amount of the loan and the value of the collateral. If you put up $10,000 worth of crypto as collateral and receive a $6,000 loan, your loan’s LTV ratio is 60 percent. Because crypto markets are volatile, LTV ratios on crypto loans are typically low.

What are the risks involved in crypto loans?

Unlike assets held in traditional financial institutions, crypto accounts are not covered by the FDIC. Consequently, there is no federal insurance on any crypto asset in the event an exchange fails. With this in mind, there are three primary types of risk inherent in crypto loans.

Technical risk

As in all cryptocurrency trading, there is a risk that protocols break down because of a technical problem or hacking. This risk is somewhat higher in non-custodial loans, since all DeFi activity is completely algorithmically governed.

Counterparty risk

The FDIC requires all traditional banks to maintain a certain level of liquidity; crypto loan providers are not subject to this requirement. If the market crashes, an unexpectedly large number of clients default on their loans, or if a platform breaks or is exploited, the crypto lending platform may find itself without the liquidity to return a borrower’s collateral.

Margin calls and forced liquidations

To prevent illiquidity during market downturns, lending platforms will issue margin calls or force liquidations. If a cryptocurrency’s value drops to a point where many borrowers’ LTVs are too high for the platform to maintain, the platform will inform borrowers that they must increase the value of their collateral or risk liquidation.

If the call is not met, the platform may liquidize enough of the collateral to bring an account’s LTV back to the maximum allowed ratio. In this case, a trader will have forfeited that portion of their deposit, will have incurred capital gains or losses, and may be charged transaction and broker fees.

How are crypto loans taxed?

If a crypto loan is managed properly and all parties uphold the terms of the loan, the parties should not incur any taxes. The IRS considers cryptocurrency to be property, and, as in traditional trading, using your property as collateral for a loan is not considered a sale and therefore is not a taxable event.

However, there are several potential crypto loan scenarios that could affect your taxes.

Crypto loan fees

Providers charge borrowers interest fees on their loans. These fees can range from around 1% APR to over 12% APR. If you use your loan for investment or business purposes, you may be able to write off these interest fees on your taxes.

Contact a tax professional for more guidance about business deductions.

Failure to pay back the loan

If you don’t pay back your crypto loan, the lender may liquidate all or part of your asset to recoup its losses. This could result in capital gains or losses for you, even though the lender retains the proceeds.

Forced liquidation

As mentioned above, if collateral is liquidized because of an unmet margin call, the borrower will be subject to capital gains tax on any increase in the collateral’s value between the time of its purchase and the time the lender sold the asset.

Self-repaying loans

Self-repaying loans, like those offered on Alchemix, do result in taxes owed. This is because the structure results in what is called “debt cancellation income.”

For example:

  1. A user puts up 20,000 DAI of collateral to the Alchemix protocol and receives a 30,000 DAI loan in exchange.

  2. Alchemix deposits the 20,000 DAI into a liquidity pool, which mints 1,000 DAI for the protocol over the tax year..

  3. 1,000 DAI is subtracted from the user’s debt to the protocol. This is considered 1,000 DAI of debt cancellation income for the user, which is taxed as ordinary income.

Ready to investigate which crypto loan is right for you? Read our recommendations for the best DeFi and CeFi lending platforms.

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